Standard Life Investments

Global spotlight aug 2012 — Draghi fails to find his showstopper

Nyhet   •   Aug 15, 2012 14:49 CEST

Intricate monetary policy deliberations were once the sole preserve of central bank geeks. No longer! ECB Governor Mario Draghi's latest policy pronouncement – in which he suggested that the central bank could be on the verge of adopting QE - received unprecedented attention. Of course, this flood of interest is partly by design; the televised press conference has become a firm favourite among policymakers in recent years, but it also has the added effect of intense market and media scrutiny.

This was certainly the case earlier this month when Draghi appeared to paint himself into the corner: 'the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. He outlined a plan that could eventually lead to open-ended intervention by the European central bank through buying shorter dated government bonds in peripheral markets. Alongside he suggested the European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM) could be activated to make purchases in longer dated bonds, albeit 'with strict and effective conditionality in line with the established guidelines'.

For a brief time, markets saw a ray of light in the otherwise unremitting gloom. The purchases proposed by Draghi could be sufficient to guarantee that peripheral governments would be able to fund themselves at sustainable rates for the foreseeable future. This would ease concerns that there is still no ceiling to peripheral sovereign debt yields. In addition, there appears to be a tacit recognition by the ECB, against the backdrop of ongoing recession, that its mandate to maintain price stability could include much more dramatic operations. Many investors have long been looking for such positioning, a step towards full blown QE, but it has appeared a distant possibility.

Subsequent statements from ECB members though demonstrated a significant number of obstacles to overcome. Not only is the ESM not yet ratified, and additionally it will take time for its capital to be raised but, more contentiously, those member countries, principally Italy and Spain, must be prepared to ask for external assistance - something that neither is definitely willing to consider. Domestically, the political fallout could be sizeable. It is also important to remember that ECB actions are not a solution, they can only buy time for governments to push through necessary reforms. This was the firm message from ECB member Luc Coene, namely that the ECB cannot take on the whole debt of say Spain and Italy onto its balance sheet. A year ago, the ECB did buy Italian bonds and, to quote Coene 'right after that the Italian government reneged on its pledges'.

This view will be held by many more within the ECB, and also helps explain the length of time it may take for Draghi to reach a sufficient consensus. Having been formed 14 years ago with a mandate to cover a Euro-zone of eleven members, which intiially did not include Greece, much of the Bank's credibility has been borrowed. In particular, the ECB has cultivated the impression that it has inherited the inflation-fighting credentials of the Bundesbank. Unfortunately, this has also proven a burden for the ECB, highlighted by the strong resistance from the Bundesbank to the previous efforts of the ECB, under Jen-Claude Trichet, to make bond market purchases back in 2010. A key question going forwards is how obstructive the Bundesbank is likely to be as and when the ECB moves closer to intervening in bond markets. Draghi has made repeated reference to the German central bank's objections, while its own president Jens Weidmann has warned that the ECB's independence 'requires it to respect and not overstep its own mandate.'

These divisions at the heart of the ECB may be a key driver behind market scepticism about the effectiveness of Draghi's game changing solution. Had he the full backing of his board, he would have made it clear that the ECB will act once the conditionality is in place. The fact that he was not even prepared to do this is revealing, with little comfort available from his comments that the long list of conditions were, 'necessary but not sufficient'.

So where does this leave investors? Are we any closer to finding a 'game changer' for the European sovereign debt saga? No, we remain cautious in our funds. Despite the initial disappointment, Draghi's plan might represent a potential escape route – it certainly lays the groundwork for the potential removal of the threat of widespread sovereign default in the region. However, several complicated series of discussions look set to take place into the autumn – within Spain and Italy to see whether they wish to apply for ECB/ESM support, within European finance ministers, to ensure that sufficient conditionality is in place, and within the ECB, that it is still holding to its underlying mandate and not destroying its balance sheet. These complicated questions are unlikely to be answered quickly, but the result will be important not only for European bond markets but also the credibility of one of the world's most important central banks. 'Two steps forwards, one step back' remains the watchwords of the Euro crisis.

Andrew Milligan, Head of Global Strategy, Standard life Investments