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Draghi's limits exposed

Draghi's limits exposed

Debtor-creditor balance worsens in euro area

by David Marsh

Mon 20 Oct 2014

Mario Draghi, the European Central Bank president, does not have full control of the ECB’s balance sheet. That much has become clear since his statement in September indicating that latest measures to boost faltering euro area inflation and get the economy moving again could increase the ECB’s balance sheet by up to €1tn.

As a result of banks’ relatively low desire to take up new ECB liquidity facilities, as well as the only limited volumes of asset-backed securities and covered bonds available for ECB purchases, the actual sum will be much less than that. The total stock of covered bonds that meet the ECB’s requirements is only €600bn, from a stock of €1.2tn. Purchasable ABS assets are only €400bn out of a stock of €690bn. It is not likely that the ECB can buy them all.

In his first year in office, which started on 1 November 2011, Draghi said relatively little but allowed observers to think he could achieve a lot. As he comes up for his three-year anniversary at the end of this month, the ECB president needs to reflect that, lately, the opposite has been true. Speaking more, but achieving a lot less, can wound the ECB’s credibility.

As other European central bankers say, Draghi is increasingly straying into areas over which he has no control, such as lecturing European heads of government on the need for structural and fiscal reform. That can only be a sign that he has his back to the wall.

Draghi’s finest hour was on 26 July 2012 when he famously announced in London, in a partly improvised statement, ‘Within our mandate the ECB is ready do whatever it takes to preserve the euro.’ This was essentially a well-timed bluff, when peripheral European debt was under siege from hedge funds, to counter the pessimists and bring down weaker countries’ bond yields from panic levels that seemed to threaten members states’ solvency and spell the euro’s demise. Some market participants hope that Draghi early next year could pull off a similar trick with full-scale quantitative easing. But there are many reasons why, compared with the position in summer 2012, Draghi now has far less opportunity for a similar psychological breakthrough.

First, the debtor-creditor balance in monetary union has become badly skewed. Debtors hate deflation and want inflation, creditors see things the other way around. The International Monetary Fund’s database on countries’ international investment positions makes alarming reading. Germany’s net foreign credit position rose to 48.3% of GDP in 2013 from 34.0% in 2009, the Netherlands’ to 46.2% from 16.7%. Italy’s net foreign debtor position increased to 29.5% from 26.6%, Spain’s to 98.2% from 93.8%, France’s (perhaps the most worrying shift) to 17.0% from 9.4%.

Second, Draghi’s guns for using the facility that grew out of his July 2012 announcement – the unused outright monetary transactions programme – have been spiked, since the German constitutional court has declared it illegal and the European Court of Justice (where a first hearing took place on 14 October) is unlikely to bring about a speedy clarification. The spreading of ‘reform fatigue’ around the euro area, seen in particular by hostility in Rome and Paris to European straitjackets on budget deficits and opposition to Berlin’s plans for a balanced German budget next year, anyway means that the fundamental condition for the OMT, further austerity policies in recipient states, cannot be fulfilled.

Third, the fall in interest rates since Draghi’s July 2012 announcement greatly limits the opportunity for profitable ECB intervention to curb excessive selling of debt. Spanish government 10-year debt in euros, despite some nervousness last week, is still yielding only 2.16%, slightly below the 10-year US Treasury bond rate of 2.21% in dollars – despite expectations that the euro is likely to fall. The notion that prices are relatively high applies to the ABS and covered bond markets too. 

Fourth, the Bundesbank and its allies in Germany and beyond are fighting full-scale QE. Political, legal, financial market and academic opposition, often voiced by highly disparate bedfellows, has been fused into a common cause. German Chancellor Angela Merkel was badly weakened by her failure to hang on to her Free Democrat coalition partners in last September’s general election. Her support for Draghi’s OMT in 2012 was not because she favours unconventional monetary policies, but because he let her off the hook by obviating the need for more parliamentary funding for debtor states. That benevolent constellation is unlikely to return.

Fifth, the most virulent debtor in the euro area (although not the biggest in absolute terms), Greece, has taken a monumental gamble by declaring that it wishes to escape the shackles of IMF- and EU-imposed austerity and rely on the capital market for government funding next year. The markets’ response was frosty – a rise in Greek bond yields to above 8%. Last week’s bout of euro area nerves is unlikely to be the last. More alarms and stand-offs – this time involving the largest euro members, Germany, France and Italy – are likely in coming months.

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