Download ECB has unlimited firepower and limited inclination to use it

25 June 2012
“Successful investing is
anticipating the anticipations of
others.”
John Maynard Keyes
ECB has unlimited firepower and
limited inclination to use it
4 October 2011
In 2008 and 2009, policymakers impressed markets with decisive action. Central banks moved
swiftly to slash interest rates and extend liquidity, beefing up balance sheets in the process.
Governments launched big stimulus programmes. The G20 meetings were a signal of a concerted
determination to act.
Things are different now. At the recent G20 summit in Mexico, more fingers were pointed than
backs slapped. Many governments are intent on tightening policy, not loosening it. Central banks
retain the capacity to act: the Bank of England announced new liquidity programmes on June 14th,
and on June 20th the Federal Reserve decided to extend a programme to hold more longer-term
bonds. But arguably the institution that needs to do most, the European Central Bank, is hanging
back even as the pressure on countries like Spain, (whose sovereign-bond yields rose to Euro-era
highs recently) remains intense.
The politicians are casting around for solutions of their own. One approach, mooted in Mexico,
would be for the Eurozone’s bailout funds (either the permanent European rescue fund, the
European Stability Mechanism (ESM) due to start in July, or the temporary European Financial
Stability Facility) to purchase the bonds of struggling countries like Spain and Italy, driving down
their yields. Such intervention has previously been conducted by the ECB via its Securities Markets
Programme (SMP), which now holds over €200 billion in government bonds.
The snag with using the ESM is that its firepower is limited to €500 billion (of which up to €100
billion is already earmarked for Spanish banks). By contrast, the ECB’s resources are potentially
unlimited. Yet Mario Draghi, the ECB’s president, has made clear that any use of the SMP should
be temporary and limited. No purchases have been made over the past three months. Mr Draghi
knows that bond buying alarms the Germans, who regard it as close to monetary financing of states
which is banned by the European treaty establishing the Euro.
And even if the ECB did start buying bonds again, the intervention might be less effective than its
proponents hope. Financial markets are now gripped by fears of “subordination” being pushed
down the pecking order of creditors. The ECB’s insistence on being excluded from the Greek
sovereign debt restructuring in March, which resulted in bigger losses for private bondholders, has
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Duggan Asset Management Limited trading as Duggan Asset Management is regulated by the Central Bank of Ireland.
set a worrying precedent. Investors now worry that any official rescue, whether by the ECB or the
ESM, will claim a similar privilege.
Another way in which the ECB could calm things down would be to fire off a third round of longterm funding for European banks, maybe providing loans for even longer than the three year term
on those made in December and February. Those two LTROs (longer-term refinancing operations)
were successful in cowing the markets, at least for a time. And the ECB feels on much safer ground
when it lends to banks (even if they then lend to governments) than when it steps into the swamp of
sovereign bond markets.
Yet the case for another LTRO is less compelling than before. The funding drought that prompted
the first two has largely been quenched thanks to the big take-up of those earlier offers, which
amounted to just over €1 trillion of three year money. Mr Draghi said on June 15th that constraints
on the supply of bank credit had been removed. As with the policy of quantitative easing pursued in
America and Britain, there may be diminishing returns to unorthodox policies: having banks load
up on even more domestic government debt is not ideal, for example.
That leaves more orthodox approaches. There are certainly compelling reasons for the ECB to ease
monetary policy. The Eurozone may have managed to dodge recession in early 2012 (when output
remained flat after declining by 0.3% in late 2011), but GDP seems to have slipped back in the
second quarter. A clutch of business surveys, including the latest ZEW indicator of confidence
among German investors, paint a poor picture of decline spreading from the periphery to the
German core. The second quarter started poorly, Eurozone industrial output contracted by 0.8% in
April from March, the monthly fall in Germany was 2%.
To counter this weakening, the ECB may cut interest rates when its governing council meets on 5
July. Its benchmark rate has stood at 1% since December. If it were to be cut to 0.5% (similar to the
rate in Britain), this would affect not just new lending by the ECB but the rate charged on the
LTROs (for which banks will be charged the average interest rate over the three years). Any
reduction would probably occur in two quarter point steps, as happened late last year when the ECB
brought down the rate from 1.5% to 1%.
Such a move may bolster Germany and other solid northern economies, but it will do little to help
the Eurozone’s foundering southern economies. The fundamental problem that Mr Draghi faces is
the acute divergence within the Eurozone as capital flight sucks funds out of the periphery and into
the core, making monetary conditions simultaneously tight and loose. In Germany, despite recent
gloom, businesses and households can borrow readily at cheap rates. In southern Europe, banks are
restricting the supply of credit, those loans that are available are expensive.
Mr Draghi has long argued that the solution to the Euro crisis lies in the hands of politicians. If
European leaders fail to deliver when they meet for yet another summit in Brussels at the end of
June, the ECB will remain in a quandary. Trying to implement a common monetary policy for the
Eurozone has been and remains a tough task.
Prepared by: Mark Holland, Investment Analyst – Duggan Asset Management.
Tel: +353 (0)1 8044982
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Duggan Asset Management Limited trading as Duggan Asset Management is regulated by the Central Bank of Ireland.