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Analysis
Making sense of the euro stand-off

Making sense of the euro stand-off

Phoney war beckons across EMU heartlands
Italy, Spain in no hurry to apply for funds

by David Marsh

Mon 10 Sep 2012

If we’re lucky, a further short run of financial market gains may be in store following the latest instalment of Mario Draghi’s ‘do whatever it takes’ performance to shore up weaker euro countries’ debt. After that, the gap between the optimistic mood of financial markets and the real political and economic position may become more apparent.

Nerves are already running thin, emphasised by George Soros’ dramatic weekend call on Germany to ‘lead or leave’ the euro and the likelihood that the German Constitutional Court on Wednesday will say ‘Yes’ to the European rescue fund (ESM), but hedge this with fresh complexities for already fraught financing packages.

Economic and monetary union (EMU) was supposed to make life simple in Europe. Instead, it has spawned a viper’s nest of fiendishly complicated mechanisms to preserve a status quo no one finds satisfactory.

In last Thursday’s announcement of conditional plans for so-called ‘unlimited’ intervention on short-term sovereign bond markets, Draghi was careful to point out that borrowing country governments will have to pull the trigger for action. They will have to ask for formal aid from the euro area’s rescue programmes (ESM and the provisional EFSF). Spain and Italy are hardly falling over themselves to apply.

Another set of governments will also have to be asked to approve aid – those from the countries supplying the funds, i.e. the full panoply of 17 EMU members. That may not be a problem for countries that are themselves in a mess. But Germany (and possibly still more the other main creditor nations – the Netherlands and Finland) could be a different story.

While the different players tackle the awkward issues behind the stand-off between the ECB, the Bundesbank and European governments, we may see a ‘phoney war’ across EMU heartlands in coming weeks. During this time, far from wading into the market to fight speculation of euro ‘convertibility’ (the ECB’s euphemism for the euro breaking up), the ECB may simply do nothing. The longer this lull in hostilities lasts, the greater may be the ferocity when combat eventually resumes.

The German parliament has an effective veto over the aid programmes that have to be in place before the ECB can move in its heavy artillery. That opens up the way to all kinds of warring and scheming between Angela Merkel’s ruling coalition and the Opposition Social Democrats, trailing in the polls ahead of the next general elections slightly more than a year from now.

Jens Weidmann, the German Bundesbank president, the one member of the 22-man ECB council who spoke out against the bond purchasing programme on Thursday, will have plenty of media-effective opportunities to put his views. It will be fascinating to see whether Weidmann appears before German parliamentary committees debating the pros and cons of EFSF/ESM programmes for Spain and Italy (if they apply). Appearing to be overly part of the political horse-trading would run counter to the Bundesbank’s famed independence. But, now that the ECB has plainly moved towards a quasi-political role, Weidmann may well cast such scruples aside.

For all these reasons, the actual amount of bonds the ECB eventually ends up purchasing could be quite modest. So far, as Draghi and his colleagues planned, markets have rowed back from their oversold positions towards the end of July, using the prospect of ECB action as a justification to reverse some of their extreme bearishness on Spanish and Italian bonds and in some cases to take profits.

Yet many obstacles lie ahead. The success of Draghi’s pre-emptive announcements in encouraging short-term investors to pile back into weaker countries’ bonds has added to governments’ reluctance to apply for aid, especially considering the additional stigma of an IMF imprimatur that Draghi has now introduced into the equation.

Mariano Rajoy, the Spanish prime minister, is clearly banking on getting the benefits of lower yields without having to take further austerity measures. A natural inclination for him, not one that will eventually satisfy financial markets.

Another risk is Wednesday’s planned judgment by the German constitutional court delineating the conditions for final German legal approval for the ESM. Although the court will almost certainly back the ESM’s constitutionality, and may not go as far as hinting on the need for a referendum (which itself would be constitutionally highly difficult), it will probably call for further safeguards to guard against constitutional violations. This could both complicate the procedures for deploying the ESM and open up a far greater volume of the ESM’s operations to German parliamentary verification. Both actions could damp the mood of relative euro optimism lately prevailing on financial markets.

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