What's the best place to publish an ECB letter setting out your country's economic policies?

Former Spanish Socialist Prime Minister José Luis Rodríguez Zapatero has upset quite a few people after he included the letter he received from the ECB and the Bank of Spain in August 2011 in his recently published memoirs. Though bits and pieces of the letter had already been disclosed, the full content was never really made public. In a radio interview today, Zapatero has justified his decision to keep the content of the message secret at the time because at least part of it "would have put stability at risk".

Courtesy of El País, we have had a look at the letter – and we thought it was worth translating a few key points:

• The first priority identified by the ECB and the Bank of Spain is labour market reform. The letter reads, “We deem it necessary to adopt additional measures that improve the functioning of the labour market […] We are enormously concerned about the fact that the [Spanish] government has not adopted any measure to abolish inflation-indexing clauses. Such clauses are not an appropriate element for the labour markets in a monetary union, as they represent a structural obstacle to the adjustment of labour costs.” 

• The letter goes on, “The government should also adopt exceptional measures to promote wage moderation in the private sector [...] We suggest revising other labour market regulations shortly, with a view at speeding up the re-integration of unemployed people in the labour market [...] We see important advantages in the adoption of a new exceptional work contract that is applied for a limited period of time, and where compensation for dismissal is very low.” 

• The second priority is the adoption of “bold measures to ensure the sustainability of public finances. The government should prove in a clear manner, by action, its unconditional commitment to the achievement of its fiscal policy targets, irrespective of the economic situation. To this end, we urge the government to announce, by the end of this month, additional measures of structural fiscal consolidation for the remainder of 2011 worth at least more than 0.5% of GDP.” “Simultaneously”, continues the text, “the application of national fiscal norms must be continued in order to ensure [central] control over regional and local budgets (including the authorisation for debt emissions by regional governments).” 

• The third priority is product market reform. According to the letter, the Spanish government should “increase the competitiveness of the energy sector in order for prices to better reflect the cost of energy” and “increase the competitiveness of the services sector, in particular by addressing the regulation of professional services.” 

Therefore, as in the case of Italy (see our blog post from September 2011), the letter was a lot more than just a push to shape up. It was a detailed and quite prescriptive to-do list in return for ECB bond-buying - even boiling down to specific policy measures and the size of fiscal cuts. Furthermore, it did not shy away from touching on politically sensitive issues for Spain – just think of the demand for more central control over regional spending or the abolition of wage indexation.

All this put the ECB squarely in the realm of domestic fiscal policy, somewhere many would agree it should not be. In any case, any country considering applying for an OMT bond-buying programme should consider these points when wondering how prescriptive the conditionality might be.

The closing paragraph of the letter sounds a lot like a warning. It reads, “We are confident that the [Spanish] government is aware of its highest responsibility in the good functioning of the eurozone in the current [economic] conjunction, and that it will adopt in a decisive manner the necessary measures to regain the confidence of the markets in the sustainability of its policies. Such measures […] should greatly benefit not only the Spanish economy, but also the eurozone as a whole.”

Therefore, it is no surprise that many of the letter’s ‘suggestions’ have become government policy – though under the centre-right cabinet led by Mariano Rajoy, who took office at the end of 2011.

ECB debate comes full circle back to QE again - but substantial obstacles remain

As with many things in the eurozone crisis, we have now come full circle in the discussion of one part of ECB policy – the prospect of Quantitative Easing (QE).

The debate over ECB QE was had when the crisis was at its peak. The motivating factor then was ensuring the euro stayed together. Now the motivating factor is low inflation/fear of deflation and low growth. The ultimate conclusion back then was that QE is not the right policy for the ECB (compared to the Fed or the BoE) for a number of practical and political reasons.

Despite the current motivation behind the debate being different, we think the key constraints still hold, while other issues over the effectiveness of QE have also come into play. Our previous thoughts are here. Below we restate our points and add some new insights.

Hard to target QE on the necessary sovereign debt: As we stressed in our previous post and note on this, any QE in terms of direct primary market purchases of eurozone sovereign debt would have to be shared out according to each countries share of ECB capital – i.e. Germany and France would see the large majority of purchases. This significantly limits any real benefit in the periphery and could worsen the crunch for safe assets in the eurozone with the price of core eurozone sovereign debt being driven even higher (and the returns going further down). The hope would be that this would spur investment in the periphery countries but given the investment patterns in Europe and the upcoming stress tests, it’s clear that demand for periphery debt remains separate from demand for core debt.

QE is very different to OMT: The exact constraints for OMT remain ill defined, but what we do know is that any purchases will be limited to short term (below 3 year maturity) debt on the secondary market, will be subject to the strict constraints of a bailout programme and the purchases will be sterilised.  What form a QE programme would take is also unclear, however, it is likely to involve significant and widespread purchases which come with no conditions and are not sterilised. 

QE on private assets might have little impact in Europe: Unlike the US and even the UK, the European market for securities is far less developed. Furthermore, the corporate sector relies much more heavily on bank loans for funding than on debt issuance (see graph to the right). If the ECB decided on a QE programme to target different securities, the impact on the real economy would be limited by the structure of these markets. This point is driven home by the graph to the right below, which highlights the broad breakdown of assets in the eurozone - significantly dominated by government debt. The ECB could purchase mortgage backed securities, which is one of the more developed markets. However, a significant chunk remain non-performing (or close) and are opaque in terms of what is included inside them and what their true market price is. In all likelihood any purchasing of private sector assets would mostly be a boost to bank balance sheets, however, unless it is sufficient to completely reverse their deleveraging and kick start lending it would probably do more than push up asset prices.

Political obstacles are significant: The programme would need approval in the ECB’s Governing Council. With a quarter already known to be against last month’s rate cut, opposition to such a significant step could grow. Even if it got through the fallout in terms of divisions within the ECB and the political blowback from within Germany could create serious problems for the eurozone. Bundesbank President Jens Weidmann even said earlier today that the ECB should not take further easing steps in the near future after the rate cut.

The overall impact on the real economy is far from clear: the discussion over this point in the US and UK has been substantial, with no clear winner. While QE did likely help to avert a deeper crisis, particularly in the short term, the fact is that there is no clear link between higher inflation or higher growth and asset purchases of the central banks.

For these reasons, we believe QE will be a very last resort for the ECB. It is practically and politically difficult. That said, it still seems like further easing is very much being considered. See for example the Bloomberg story today about the very real possibility of a negative deposit rate (which has weakened the euro significantly). Such a move would itself of course come with drawbacks and difficulties, but we’ll leave them for another post.

ECB preview – ECB edges towards rate cut as inflation drops

Interest has grown in this month’s ECB meeting, after inflation surprised on the downside last month, falling to 0.7% - far below the ECB’s 2% target.

In all likelihood, the discussion will not be too different from previous monthly meetings, but there are a few points worth flagging up.

A rate cut in November or December?

• The consensus is now moving towards a rate cut this month, or more likely next month. As we pointed out before, this will have little impact given that rates are completely detached from the ECB’s main interest rate and the transmission mechanism remains broken in much of the eurozone. Ultimately, it is a signal that the ECB is keen to keep loose monetary policy. 
• The ECB, though, could well hold back for a few reasons. Firstly, it probably wants to see how the nascent recovery in the eurozone develops. Secondly, it knows this is probably its final rate cut and wants to time it correctly. Thirdly, its medium-term forecast is for inflation to recover (although this is likely to be revised downward in December). 
• FT Alphaville also highlights the interesting point that, given that this will likely signal the end of rate cuts, the response could even be a slight increase in market rates.

A new LTRO in the New Year?

• The shrinking of the ECB balance sheet continues, as eurozone banks are repaying the LTRO loans. Liquidity is dropping rapidly in the eurozone and short-terms rates have edged up somewhat – creating a de facto tightening of ECB policy. This is exacerbated by the continued easing bias by the other global central banks.
• That said, the previous LTROs have served to increase the sovereign-banking loop. They also remain a blunt tool since the amount of liquidity injected relies on demand, while the prospect of this lending being stigmatised under next year’s stress tests could discourage banks from tapping it.

Euro strength weighs on the ECB’s mind

• The strength of the euro in recent weeks, particularly against the dollar, has been covered widely with an increasing number of investors and politicians calling for action on this front. 
• Although the ECB has stressed that it does not target the exchange rate, it has shown before that it certaintly considers it. Draghi has shown a willingness to ‘talk down the euro’ previously, and is likely to try and do so again. However, turning this into lasting success is tricky and clamour for more concrete signs could increase.
• Failure to address the issue also leaves the currency open to volatility, as markets struggle to interpret the ECB’s vague signals and balance them with more defined ones from other central banks.

What to do with the deposit rate?

• This is another aspect weighing on the ECB’s collective mind. As we pointed out before, a cut to negative territory could have many unintended consequences, and is unlikely to be risked in anything but the worst circumstances. Still, the desire to maintain some ‘corridor’ between the regular rate and the deposit rate could make the ECB think twice about cutting rates at all.

As the above suggests though, we stick by our view that the ECB does have limited tools to help promote economic growth. This meeting is also likely to be another test of its new communication policy and whether it can really have lasting market impact. Ultimately, though, pressure for some concrete action from the ECB is likely to increase as long as inflation remains subdued.

Otmar Issing: EU will only live up to expectations when tendency toward centralisation and bureaucratisation resisted

This post is part of a series of interviews carried out by our sister organization, Open Europe Berlin. To read the original interview between Otmar Issing, the former Chief Economist of the European Central Bank, and Open Europe Berlin in German click here.

Otmar Issing addresses the audience at the Open Europe Berlin launch, Oct.2012

OEB: What does Europe mean to you?

Issing: Following the terrible wars and dictatorships of the past, for me, Europe means a continent of peace and freedom.  The freedom to travel, and particularly for young people -- to learn, study, and to make friends beyond national borders. The single market, a barrier-free market serving over 500 million people, is the economic dimension, and the prerequisite for prosperity and employment in Europe. 

OEB: What does the European Union mean to you?

Issing: The European Union embodies the institutional structures, which preserve the aforementioned achievements.  The European Union will live up to expectations only when the tendency towards centralisation and bureaucratisation are resisted. 

What does the euro, the shared currency, mean to you?

Issing:The euro represents a promise of a stable currency to the citizens of the euro area.  During the first 14 years of the euro, the central bank fulfilled this promise by way of its obligatory price stability policy.  However, the existing economic policies of many countries continue to be contradictory to [the ECB's] policy, which is absolutely necessary to the guarantee of long-term stability for the euro and the eurozone. 

"If the euro fails, then Europe fails!" To what extent do you agree or disagree with this statement?  

Issing: Europe is far more than the euro. It is more than currency and economy. But a collapse of the euro, which I consider rather unlikely, would indeed cause considerable economic and political turbulence and it would set European integration back. 

'More Europe' in which form of the EU? In which policy areas should the European Union (a) do more; (b) change its practice; or (c) do less? 

Issing: ‘More Europe’ is a mantra, which in my opinion, lacks concrete content and easily leads to the misguided adoption of ever further centralization.  Should the EU wish to realize its aspiration of becoming the leading voice for Europe on the global stage then it must:

• Create the preconditions for growth and employment;
• Encourage the individual member states to take responsibility for the implementation of necessary reforms;
• Accommodate the principle of subsidiarity, rather than continuing to shift competencies to the European level. 

Eurozone inflation hits its lowest levels for three years

Eurostat yesterday released its latest inflation statistics and the data for the eurozone provides some food for thought.

Inflation reached its lowest levels (1.1% on an annual basis) since February 2010. This might seem surprising on the surface given all the talk of a eurozone recovery and a turn around. Why hasn’t inflation followed? Well, generally inflation is a lagging indicator and therefore any recovery will take some time to feed through to prices and wages. However, as the graph below suggests, there is more at work here.

There has been significant disinflation (falling inflation but not negative inflation, which is deflation) in the eurozone and more importantly in the PIIGS. For all the talk of internal devaluation in the eurozone it has taken some time to feed through to the Consumer Price Index (CPI). Due to factors such as indirect tax increases and sticky prices and wages, it has taken some time for the impact to be fully felt – now that this is beginning to happen it is unlikely to stop immediately and could carry on for some time.

The data also shows that because of the effect described above, inflation in the PIIGS is diverging from the rest of the eurozone somewhat and particularly from the stronger countries in the north.

What does this mean for the ECB?

The FT has a couple of pieces today discussing this, calling on the ECB to do more to tackle the disinflation in the eurozone. While inflation is clearly well below the ECB’s target, the current nature of the inflation does present some issues for ECB policy.

• Firstly, there is the standard one size fits all conundrum – as inflation plummets in the PIIGS it remains stable in the north and threatens to increase as these countries post higher levels of growth. Adjusting the policies to suit these countries more could prompt unwanted outcomes in the stronger countries. Politically, it’s also worth remembers just how wary Germans are of inflation, as we highlighted recently. Finding the correct line between these two camps is incredibly tricky for the ECB.

• Secondly, while the struggling eurozone countries could use a boost in demand, the ECB may struggle to find the necessary targeted approach to do this. One measure which has been widely mooted is another long term refinancing operation (LTRO) to help boost liquidity in the market. However, as the graph above shows, there was no boost in inflation from the previous rounds, despite it totalling around €1 trillion. This is largely because the money did not filter through to the real economy and therefore did not impact consumer price inflation. Although things are improving there is still plenty of fragmentation in the market and loans to the real economy continue to fall in the PIIGS.

• This point also applies more generally in our view in terms of the tools at the ECB’s disposal. As we discussed at length here, although the ECB can do much to stop the break-up of the euro, it has fewer tools to help promote economic growth in the current circumstances, particularly in specific economies.

• In our view disinflation is not such a risk for many of these countries, in fact many need to see reductions in prices and wages to help boost their competitiveness, although it does of course have knock on impacts for their already flagging GDP growth. That said, deflation is a bigger risk because these countries have such large debt to GDP levels, which would only be exacerbated by deflation – although for countries such as Greece the need for further debt relief is already very apparent so the marginal impact of deflation is smaller.

All in all then, low inflation in the eurozone seems here to stay for some time due to the periphery pulling the average down, even if a fuller recovery eventually materialises. This will create some new issues for the ECB to deal with, however, given the divergence between countries it may well struggle to find the tools to have a big impact on this.

Italian PM Letta survives key confidence vote: What's next for Italy?

What looked like an imminent political crisis has just been defused in Italy. As we anticipated in our previous posts (see here and here), Italian Prime Minister Enrico Letta has managed to survive a vote of confidence in the Senate - the upper chamber of the Italian parliament where his Democratic Party doesn't hold a majority.

In a last-minute U-turn, Silvio Berlusconi has decided that his party would support the government after all - turning a potential showdown into a mere formality. Nonetheless, what just happened in the Italian Senate does have consequences for the future of Italian politics. Here are a couple of thoughts.

1. Letta stays on, but uncertainty remains over what his government can deliver

The first, and most obvious, immediate consequence of today's vote is that Enrico Letta can stay on as Italian Prime Minister and maintains, at least on paper, his overwhelming parliamentary majority. However, it remains to be seen what Letta and his cabinet can deliver in terms of bold, concrete measures to get Italy going again - not least because some fundamental differences between the parties forming Italy's ruling coalition will remain.

One may argue that, faced with a party mutiny ahead of today's vote, Berlusconi would have finally learnt his lesson and would think twice before triggering new crises in future. But we wouldn't rule out new coalition rows. Berlusconi is famous for his CEO-style handling of his party, and he tends to take all the big decisions on his own - which makes him a very unpredictable coalition partner.    

Another important issue is: how long will Letta stay in office for? It's no secret that both him and Italian President Giorgio Napolitano would like the current government to continue at least until after Italy's rotating EU Presidency (July-December 2014) - and then perhaps go to early elections at the beginning of 2015. This would still be much earlier than 2018, when the current parliamentary term is supposed to end.

Questions will also remain over whether, if the crisis deepened once again, Italy would really be able to gain access to the ECB’s bond-buying programme, the OMT. As we mentioned above, Letta has clearly won the day - but uncertainty remains over his government's ability to push through unpopular measures.

Crucially, the ECB has made it clear that any country accessing the OMT must have a credible government in place to enforce the necessary conditionality attached to bond purchases (very likely to involve significant structural reform and budget cuts).

2. This is not the end for Berlusconi, but he's just been dealt a hard blow 

There's another reason why today's confidence vote is significant. Looking beyond the appearances (and the last-minute coup de théâtre) Silvio Berlusconi has, in substance, seen his plan to bring Letta's government down disrupted by a rebellion from within his own party. Last weekend's decision to pull his ministers out of cabinet has therefore proved a miscalculation, and will have at least two consequences:

• Berlusconi's threats to bring the government down if he's voted out of parliament as a result of his recent tax fraud conviction are no longer credible; 

• 25 senators from Berlusconi's party have this morning announced the creation of a breakaway group in the Italian Senate, irrespective of how the rest of the party would have voted. Though far from certain at this stage, today's defectors may well decide to follow up and quit Berlusconi's party - which in turn may reduce Il Cavaliere's electoral strength.

Berlusconi has shown his resilience several times, so we are unlikely to be witnessing the end of his political career just yet - even after he's ousted from parliament. Let's not forget that polls suggest he maintains quite large public support, with the help of his control over a large swathe of the media. We wouldn't expect him to take this challenge lying down. That said, his leadership of Italy's centre-right forces has today unequivocally been put into question.

These are our preliminary thoughts. We'll continue monitoring the situation in Italy very closely, so keep following us on Twitter @OpenEurope and @LondonerVince for all the updates.

An EU bank bailout facility?

Bloomberg reports on a potential proposal by the European Commission to alter the EU’s ‘Balance of Payments’ (BoP) facility to allow it to aid banks which may need to be recapitalised in the aftermath of next year’s ECB Asset Quality Review and the EU's bank stress tests.

As a reminder, the BoP facility was originally created to aid countries with currency crises that may impact the rest of the EU or the fundamental stability of the state. It has since been adjusted to apply to only non-euro members and seen its scope widened slightly with its budget increased to €50bn due to the financial crisis. It is guaranteed by the EU budget and therefore ultimately by the member states - with the UK underwriting around 14-15%.

What is the rationale behind this move?

• Next year’s stress tests are hopefully going to be the most stringent and comprehensive so far, yet there are fears that, without clear aid to help banks found to be in trouble, supervisors may shy away from revealing any deep problems.
• This is backed somewhat by the ECB’s insistence that the stress tests will not be able to be effective unless there are clear backstops for banks in place.
• The eurozone does have some form of backstop in the shape of the ESM which can provide aid to banks (via states) but also has a direct bank recap tool.

Can it be done?

• The most likely approach would be to use Article 352 (the flexibility clause) to adjust the regulation establishing the facility.
• However, the facility also has a treaty base, Article 143, which specifies lending to states. For this reason, it seems unlikely that a direct recapitalisation tool could be added but a credit line which is lent to states to solely aid banks could potentially be. This could come with less or more specific financial sector conditions than other loans (for example see ESM and Spanish bank bailout).
• This would require unanimous approval in the Council. So far, Germany and the UK have expressed scepticism based on the fear that a backstop would reduce the pressure on banks (and their governments) to reform and clean up ahead of the tests.

Could it be significant?

• Yes. If it were approved it would create a collective fund to salvage banks should a member state be unable to deal with the problem alone. If the UK were to approve the move it could open up the door for future pay-outs of funds to aid other countries' banks – decisions taken under qualified majority voting. 
• Furthermore, it also seems to be driven by events in the eurozone. Firstly, it seems an attempt to extend this centralised banking union model (to break the so-called sovereign-bank loop) to the entire EU - even though the other countries have already rejected this to a large extent. If they really wanted to join the banking union, which some might, there will be chances for them to engage directly.
• The creation of the fund would raise some serious questions. Will this backstop exist without strong influence over the amount of risk taken in or the relative size of banking sectors to governments across the EU? If so, surely that creates a moral hazard problem. If not, it would necessitate far greater powers over member states' financial sectors. 
• Lastly, it highlights the level of concern around the health of many of the EU's banks. This was furthered by the EBA's recent assessment that the largest EU banks are some €70bn short of where they need to be to meet the new Basel III rules.

A subtle shift in German policy on banking union?

With talk of the upcoming German elections dominating over the weekend, a potentially important yet subtle shift for post-German election policy on banking union may have received less coverage than it ought to have.

Reuters reported on Saturday that Germany is working on plans to create a single eurozone bank resolution mechanism (SRM) within the EU framework without the need for changing the EU’s treaties – something the German government had previously insisted was necessary because it deemed the Commission had no legal base for the proposal to give itself the power to order banks to be wound down. Bloomberg followed this up with a report suggesting a tentative agreement had been struck with the Commission which would see the new resolution fund cover only the largest eurozone banks, thereby exempting the German savings banks (and their large pool of deposits).

German Finance Ministry spokesman Martin Kotthaus has since played down any German proposal, but stressed that "very many other member states" have also raised similar concerns to those of Germany.

It remains early days then, with lots of negotiating still to go but this could have important implications for the eurozone and the UK which are worth exploring.

What could this mean for the eurozone?

• As we have noted, Germany essentially had two choices following its stark rebuke of the Commission’s SRM plan – either work within the framework to alter it or propose an intergovernmental alternative (a similar ad-hoc set up to the temporary bailout fund EFSF). Judging from these developments it seems to have gone for the former, on the surface this is positive for the eurozone since any SRM enshrined in EU law will look more lasting and solid.
• That said, the German plan (if there is one) would clearly involve further watering down a mechanism which already looked woefully short of what was needed to help shore up the eurozone banking sector.  The crisis has clearly shown that smaller parts of the banking sector can cause significant problems (see Spanish cajas).
• The Commission is likely to have less responsibility but it remains unclear where the power will lie. Creating a new institution is impossible without treaty change while using existing ones for eurozone-specific tasks creates serious questions about the single market. The fundamental question of who decides to wind down a bank in crisis remains unresolved.
• Even if the above issue is settled, oversight of the banking sector would still look fragmented with many different institutional layers including – national regulators and supervisors, the ECB and the new SRM as well as possibly the ESM. Furthermore, the Council of Ministers, European Parliament and national parliaments will all have a role in decision making and/or accountability.
• Other problems, including the size of any resolution fund, remain – as we have pointed out. Last week’s legal opinion from the Council of Minister's legal service noted that the national budgetary implications of an EU bank resolution mechanism meant that the Commission's proposed legal base might need to be rethought.

What does this mean for the UK and other non-eurozone countries?

• How the SRM is established could well set the tone for future eurozone integration, therefore ensuring it does not alter the dynamic of the EU to serve eurozone ends using a single market legal base is important for both the UK and other non-euro countries.
• That said, a purely intergovernmental legal arrangement, outside the EU treaty, could reduce the UK's ability to influence the outcome still further. The upshot being that there probably needs to be a treaty change to ensure eurozone crisis resolution is kept distinct from and yet compatible with the single market. 
• Despite this latest attempt to avoid treaty change, Finland has also voiced concerns about the legal base for the SRM, while Germany still has concerns about the separation between the single supervisor function and monetary policy at the ECB - suggesting treaty change as solution. So, both are still keen on shoring up the banking union via treaty change in the not too distant future.

Some interesting developments then, but a long way to go yet. In any case the time line for the banking union looks the same with the process being phased in over the coming years to 2018 – far from an immediate solution to the crisis.

Meanwhile, the whole discussion over the extent to which the treaties can be stretched to help solve the eurozone crisis once again reminds us of the inherent tensions and structural flaws in the current eurozone/EU setup. Even if not done through the banking union, this will have to be settled at some point.

ECB preview - is the ECB already seeing the limits of its new communication policy?

The ECB holds its monthly meeting today in what may be seen as the most positive eurozone economic environment for some time.

Having previously been earmarked as a meeting which could see a further rate cut (a prediction which has evaporated due to more positive economic data) this meeting is now likely to be dominated by ECB President Mario Draghi’s attempts to restate his new communication policy.

July saw the launch of this policy, focused on ‘forward guidance’ (forecasting future interest rates) and the potential publishing of minutes of ECB meetings, in an attempt to add a new tool to the ECB’s monetary policy arsenal. However, in recent weeks there have been indications that the ECB may already be seeing the limits of such an approach.

Forward guidance struggles

• As the chart above shows (via Commerzbank) indicators suggest that future overnight short term interest rates are expected to increase, while the borrowing costs for short term bunds and other core eurozone countries have also been creeping up. Expectations of an ECB interest rate increase have also been brought forward significantly, whilst the euro has also been strengthening recently.
• Much of this is off the back of recent good data from the eurozone, of course a positive, but given that the data is far from comprehensive and problems still abound for the eurozone its clear the ECB is not yet ready to change course.
• Of course, given that it is early days for this policy and that the rate moves have been small it is impossible to draw a definitive judgement just yet, but there are signs of limits to the policy.

ECB Total Balance sheet (€m)

• The ECB is also seeing its monetary policy being effectively tightened as the Long Term Refinancing Operation (LTRO) loans are repaid, with its balance sheet shrinking (chart above) to its smallest size since the start of 2012, and no signs of banks increasing lending to the real economy to compensate. Again, a positive indicator but not quite what the ECB might have wanted with the introduction of a new tool indicating loose monetary policy for some time.
• External conditions have also not been helping. The Bank of England is facing a similar issue, for similar reasons, while the US Fed has announced the prospect of slowing down its Quantitative Easing programme – the much maligned ‘tapering’. This has unsettled markets and threatens to reduce liquidity globally – so far much of the pain has been felt in emerging markets, but it could yet spill over into peripheral Europe, hitting demand for government and corporate debt and pushing up borrowing costs.

Backing away from minutes

The other part of this new communication strategy was a move towards publishing minutes of ECB Governing Council meetings, with many ECB members issuing support. However, there are indications that this may also come up against problems (as might have been expected).

The concern has always been that divergent views within the ECB (read, from the Bundesbank) would make ECB minutes more trouble than they’re worth. Over the past few weeks we have seen the Bundesbank use its monthly bulletin to warn that rates could still increase and attempt temper the commitment under ‘forward guidance’, while its President, Jens Weidmann, has also warned of the potential "pressure" on decision makers if minutes were published. Additionally, comments from Austrian Central Bank Governor Ewald Nowotny suggested that the ECB might be backing away from the plans (such interventions are rarely made without some approval from the ECB hierarchy as we saw when minutes were proposed):

“My personal view is that of the founding fathers of the ECB…They were very cautious to secure the independence of the ECB by not giving minutes on the individual votes of the members of the Governing Council.”

All these factors then, have worked to expose some of the frailties of the ECB’s guidance policy, not least that it remains much more vague and unfocused than those employed at the US Fed and the BoE. The ECB (with some good reason) is hesitant to get into specifics over the timeline and conditions for keeping rates low – this will clearly hamper the usefulness of this policy tool (and brings us back to questions about how many tools the ECB really has at its disposal).

In fact, there is already talk of using another LTRO to bolster this policy and help stop any upward movement in rates, although given the limited impact of the initial LTROs (beyond avoiding a bank funding crisis) this may not help much.

All that said, the ECB is unlikely to drop its new communication approach in the near future, leaving Draghi the unenviable task of continuously restating the ECB’s commitment to this policy – expect this to begin in earnest at today's meeting.

German election update: Lucke hits back

An interesting story caught our eye in today's Welt concerning next month's German elections. Bernd Lucke, the head of the anti-euro Alternative für Deutschland party (seemingly undaunted by a recent attempted assault on his person) has written a letter to German President Joachim Gauck asking for access to documents in which the German government has simulated different scenarios to save the euro, citing Germany's freedom of information laws. The move fits with the party's theme of "having courage for the truth" (Mut zur Wahrheit), which it accuses other German political parties of lacking.

This comes after the same request addressed to the Chancellery, Bundesbank and German banking supervisor Bafin was rejected on the basis that the information is held by the eurozone's network of central banks, and therefore falls outside the scope of German law. Lucke has criticised such "questionable" behaviour on the part of German officials, while noting that the Bundesbank's refusal to reveal the information shows that it is de facto supporting the German government when it should be a politically independent actor.

While we're not expecting the information to become public soon, the documents would certainly make for interesting reading as they would reveal how the German government assessed the costs of a breakup, and therefore whether its subsequent policies for dealing with the crisis have indeed been 'alternativlos' as Merkel has argued, or whether alternative policies were jettisoned due to the short-term political and/or economic implications.

A shift towards greater transparency at the ECB?

As we reported in today’s press summary, there has been an interesting development in the push for greater transparency at the ECB.

In a joint interview with Süddeutsche Zeitung and Le Figaro, Benoît Cœuré (BC) and Jörg Asmussen (JA), ECB Executive Board Members, both supported the longstanding call for the ECB to publish the minutes of the meetings of its Governing Council, saying:

BC: “Transparency is important for the effectiveness of monetary policy and for trust in the central bank. There was a time when the ECB was ahead of the curve in its communications and transparency as first central bank with regular press conferences by its president. Now the ECB is the only large central bank that does not publish its minutes of meetings. There is a demand in society for transparency and accountability. Therefore, I personally think that the ECB should start publishing its meeting minutes soon.”

JA: “The minutes should include who voted for what, and the reasoning behind that vote. Publishing the minutes will sharpen the European mandate, because the ECB will then have to explain why its decisions are in line with the European mandate.”

BC: “The other side of the coin is, as Jörg has said, that the Governing Council has a European mandate. The governors of the national central banks come here in a personal capacity – they do not represent their institutions or their countries – and should be accountable for what they do.”

This is something which many (including ourselves) have supported for some time (see here for a House of Lords report from 2003 which provides an interesting discussion of the issue), particularly during the crisis where the opacity of the ECB (on issues such as bond purchases, legal documents and potential policies) has at times caused confusion and uncertainty. It has also hampered the accountability of the ECB and its members despite the bank playing a central role in the crisis resolution.

But all that has been true for some time, so why might the ECB be changing its tune now? The most likely reason seems to be a switch in the communication policy of the ECB, which began last month with the change to ‘forward guidance’ (forecasting future interest rate policy). Although, this did little to change the substance of ECB policy (frankly everyone knew rates would be low for some time) it is a clear shift in tactics and rhetoric. Publishing minutes fits well with this new approach for a few reasons:

• It allows the ECB to provide further detail about its decisions and what the key motivating factors were.
• It highlights the discussions of various options which the ECB may be considering to combat the crisis, this could help telegraph future action and impact market sentiment without the need for an actual decision to be taken.
• It will demonstrate the weighting of support within the council for certain policy options, again providing further detail on likelihood of future actions but also the strength of feeling on various policies (i.e. a clearer picture of the dovish or hawkish nature of the council).
• Can be used to communicate concerns to the market and other policymakers which may not have warranted inclusion in the monthly press conference of the ECB President Mario Draghi. Furthermore, if published with a delay, can allow for reflection on the impact of different policies.
• Essentially, it provides a further tool in the arsenal of the ECB to help communicate with markets and achieve policy goals. As we have noted, the ECB has recently looked increasingly policy constrained and so any additional tool would likely be welcome.

All that said, the impact of this tool should not be overplayed. It is ultimately a small aspect of overall ECB policy, its main benefit is that it can provide further nuance to some of the blunter instruments (interest rates etc.). From an outside perspective it could provide a much needed insight into the decision making process – although this will ultimately depend on the credibility of the minutes (will they really reflect the true nature of the discussion) and when they are released.

On top of this, FAZ is reporting this afternoon that the ECB and national central banks will publish more details on the notoriously secretive Emergency Liquidity Assistance (ELA), although the article seems to suggest they may only release the framework or rules of ELA rather than details on its practical use and application. Still this would be a welcome, if small, step towards transparency.

Some steps towards greater transparency then, however, the underlying motivation seems more likely to be to give the ECB another tool in its new communication strategy rather than increasing accountability as an end in itself. Either way greater insight into the opaque institution playing a key role in the crisis should always be welcomed.

Open Europe Berlin interviews Prof. Bernd Lucke, leader of Germany's anti-euro party AfD

Our German-based partner organisation Open Europe Berlin has published on its blog an exclusive interview with Professor Bernd Lucke - founder and leader of Germany's new anti-euro party Alternative für Deutschland (AfD). We have translated some of the most interesting bits.

On the topic of design flaws in the European Monetary Union (EMU)...

Bernd Lucke (BL): The root of all evil is, in my assessment, the fact that the European Treaties did not provide, and do not provide until today, for the possibility to withdraw from the eurozone...Since leaving [the euro] as a last resort was excluded from the outset, the possibility of exerting political pressure on member states was also limited.

[…]

Despite non-sustainable economic development in some countries, the financial markets obviously did not pick up on the large differences [between eurozone countries], which affected the risk of credit default. In turn, the low interest rates 'funded' these developments.  Actually, the alarm bells should have been ringing in view of the different developments in country-specific inflation rates, unit labour costs and trade balances. Also, the housing bubbles in Ireland or Spain should have been recognised and counteracted upon by politicians. However, warning systems were not available. It was revealed how ill-conceived the introduction of the euro was, under all aspects.

On the role of the ECB in the crisis...

BL: The ECB is not directly to blame because it was simply a part of the poorly constructed euro system...In the time before the crisis, the ECB could have been blamed at most for not pointing out the dangers associated with different inflation rates in the euro countries...Just a note: an independent central bank is good. But a central bank – like the ECB – that is no longer subject to state or democratic control and has switched to self-preservation mode is extremely dangerous.

On using tools such as the ESM and OMT to stabilise the eurozone...

BL: The ESM is ultimately a giant institutionalised eurobond, and therefore a form of debt mutualisation...What we want as AfD is...the return to the Maastricht criteria, and in particular the re-introduction and strict compliance with the no-bailout clause. No country shall be liable for the debts of other countries...Countries should and would go bankrupt, which would reduce the partly unbearable debt levels.

On how AfD sees a eurozone break-up...

BL: As an ‘immediate measure’, we demand the consequent compliance with the [existing] rules of the European Treaties as well as adding a euro-exit clause to the rules. If necessary, we want to force this right to exit by blocking future ESM loans with a German veto. Without further assistance loans, the crisis countries would decide that it is in their own interests to exit the monetary union. This should happen in an orderly and gradual [manner]. On the legal side, the European treaties need to be changed. We have parliaments and governments for that. And Germany has enough weight to push this through.

Athens strikes another bargain in Brussels, but how long will this one last?

As we noted last week on CNBC, a deal was always likely this time round in Greece:

"We've got German elections coming up in September and no one wants to have that talk of how we're going to fund Greece for the next three or four years. So they just want to kick the can down the road until after the elections…They will come to some agreement but it's clear that Greece is well behind track on its programme once again and it's only a matter of time before a new funding gap opens there."

One was eventually reached yesterday morning with details filtering out overnight.

How much will be disbursed and when?

• The eurozone will provide €2.5bn this month and €500m in October, while eurozone central banks will provide €1.5bn and €500m at the same time by releasing profits from their holdings of Greek government bonds. This should give Greece enough cash to cover costs and payoff the €2.2bn of government debt maturing in August.
• The IMF will hold a meeting later this month where it is expected to agree to release its next €1.8bn share of the bailout.
• The staggered pay-out of this €6.8bn will allow the eurozone to enforce more conditionality, meaning it could delay the future tranches if Greece does not stick to its reform programme.
• Once this round of funding is complete, Greece will have received around €208bn out of a total €246bn committed.

What does Greece need to do?

• The bargain comes with strict conditions on Greece (as always), particularly in terms of civil servant cuts on which Greece seems to have fallen far behind. Greece must put 12,500 civil servants in the labour mobility scheme within the next few weeks (where they receive reduced pay and are sacked within a year if they do not find a new position).
• This must be doubled by the end of the year, while 15,000 must be laid off by the end of 2014.
• Greece must also work to step up reform of the tax system, tackling evasion and improving collection of back taxes. This is obviously easier said than done and has been a target from the beginning, no details yet as to how this time round will be any different.
• Must close the funding gap in the healthcare provider EOPYY which totals around €1bn. Again no details as to how and when exactly this will be closed.

Unanswered questions

• On top of the ones hinted at above, the key unanswered question remains, how will Greece fund itself once the bailout runs out? The eurozone has already further committed to €11bn in aid (unlikely to be in the form of direct funds) in 2014 and 2015 although it is yet to identify where this will come from. Eurogroup head Jeroen Dijsselbloem dismissed such concerns saying, "If there is a financing gap it will be at the end of 2014, which will allow us plenty of time to deal with it," which provides little comfort given the delays in dealing with other eurozone problems.
• Can the government actually push through all these measures with its slim majority? We expect it will probably be able to (just), but it will be the first real test for the new coalition and will provide a good bellwether of how it will fair in the coming months.
• What is happening to the closed state broadcaster ERT? This remains unclear. This is important not just for political reasons (still has the potential to expose divisions in the coalition) but also since the 2,600 employees could provide a big boost towards meeting the targets for civil servant cuts (the real reason behind the closure in the first place we suspect).
• Another key aspect of the recent funding gap was the reluctance of national central banks to rollover their holdings of Greek bonds (thereby reducing the amount Greece has to pay off). It’s not clear whether this has been done or will be done, although comments from officials this morning suggest it may not yet be finalised.

Another bargain very much along the usual lines of cash-for-reforms. Questions over Greece still loom large, it is not clear that they will be able to push through these public sector reforms having failed many times before. Given the lukewarm comments from the Troika it seems that even they expect another funding gap to open soon. Meanwhile as the end of the bailout approaches the fundamental issue which the eurozone has been avoiding for some time – how to fund Greece for the next decade – will need to be dealt with.

Doves dominate as central banks show the way ahead in Europe

While the US has its Independence Day, Europe looks to be having its Forward guidance day.

Bad puns aside, it’s actually been quite an interesting day in the world of central banking in Europe.

First we had the new Bank of England Governor Mark Carney surprising the markets somewhat suggesting that the increase in rates which had seemingly been priced in was premature. Essentially, providing forward guidance that the BoE would keep monetary policy loose.

More interesting for us though, was that the ECB took a similar despite not much being expected to come out of today’s meeting. Below are the key points from ECB President Mario Draghi’s press conference:

• “The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.” This is essentially forward guidance (forecasting what policy will be in the future). It’s not full because there is no clear date set but still it is a big change from Draghi’s previous line of “we never pre-commit” (this has also been the line of the ECB generally since its inception). He also added at the end, “all in all we said our exit [from loose monetary policy] is very distant”.

• Draghi also stressed that the decision on this form of ‘forward guidance’ was unanimous (numerous times in the Q&A). Again surprising since the Bundesbank has previously warned against the problems of loose monetary policy, so one might expect Bundesbank President Jens Weidmann to be wary of committing to it for an extended period.

• When quizzed about whether the ECB was now simply reacting to the US Fed’s talk of tightening its monetary policy (the much maligned ‘taper’ which has sparked market volatility) Draghi insisted that the ECB takes its actions independently of those of any of the central bank. Behind the rhetoric though it seems fairly clear that the Fed’s policy has had an impact on European and global markets and the ECB felt the need to compensate for that. Draghi also said it was simply a “coincidence” that the BoE took a similar policy approach on the same day.

• As for the rest of the press conference, it was much as expected (more of the same). Draghi continued to stress the need for structural reform and for the creation of a clear banking union with a working resolution mechanism to recapitalise banks in the event that ECB find capital shortfalls when it does its asset quality review (stress test) next year. Draghi also distanced the ECB once again from action to boost lending to small and medium sized enterprises.

It seems all this caught markets somewhat unawares with stock markets rallying and both the pound and the euro weakening in response.

This suggests that central bankers may have a trick or two still up their sleeve, although the response is likely to be short lived. Ultimately, this is not a sea-change in the policy of the ECB, the fundamental challenges facing Europe remain.

Portugal's coalition fights to keep its head above water

UPDATE (17:15) - First reports of an agreement to keep the coalition alive. Stay tuned for more details.

UPDATE (16:40) - Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas have just come out of another (swift) round of talks.

The outcomes of their third meeting in less than 24 hours are still unclear. Passos Coelho is now heading to the Belém Palace - where Portuguese President Aníbal Cavaco Silva is waiting for him.

UPDATE (14:45) - The second meeting between Portuguese Prime Minister Pedro Passos Coelho and Foreign Minister Paulo Portas is over. It was "very positive" - according to the Prime Minister's office - but inconclusive. Negotiations over a new coalition agreement will therefore continue.

According to the Portuguese media, Portas may backtrack on his resignation. If he did so, he would reportedly be appointed Deputy Prime Minister (the post is now vacant after former Finance Minister Vítor Gaspar quit) and Economy Minister (which in Portugal is a separate portfolio from Finance Minister).

More interestingly, a source quoted by Diário Económico suggests that a revamped coalition agreement would involve discussing "a new compromise with the [EU/IMF/ECB] Troika" - so potentially a relaxation of Portugal's deficit and reform targets.

ORIGINAL BLOG POST (11:25) 

As we noted in yesterday’s flash analysis, tensions in the Portuguese coalition reached critical levels over the past few days. They have eased off somewhat overnight, but there is still plenty of uncertainty around.

Key developments:

• Despite tendering his resignation from his post as Foreign Minister, the leader of junior coalition member CDS-PP, Paulo Portas, now seems to be backtracking somewhat. This is down to both internal pressure from his party, which is clearly not keen to be seen as bringing down the government, and external pressure from markets and eurozone partners over fears of snap elections which would delay the implementation of key reforms in Portugal.

• Portas already met Prime Minister Pedro Passos Coelho, with another meeting due later this morning. The two will also meet Portuguese President Aníbal Cavaco Silva this afternoon.

What are the potential outcomes?

• Portas is reportedly seeking a renegotiation of the coalition agreement. At the moment, it's not entirely clear whether his desire is more power for his party or less focus on austerity - or both. The former seems possible, although his party is significantly smaller (Passos Coelho's Social Democratic party controls 108 seats compared to 24 for CDS-PP). The latter seems less likely. The government has very little scope to adjust its economic policy due to the bailout requirements, while, as we noted yesterday, austerity and structural reforms need to continue with the country already falling behind in terms of implementing its programme.

• It is, of course, still possible that no agreement is reached and the CDS-PP confirms its withdrawal from government. However, the Portuguese media seem to agree that, even in that case, CDS-PP would keep granting parliamentary support to the government (an arrangement the Portuguese call incidência parlamentar).

• No matter the outcome, the divisions within the coalition are clear and present. There are likely to be some tough votes to come, particularly on labour market reform and further budget cuts. Whenever these take place, the spotlight will be on the coalition to see if it holds up under pressure.

We will continue to update this blog throughout the day with developments and news as we get them.

Portugal's Finance Minister quits: A bolt out of the blue? Not really...

A surprise development in Portugal this afternoon, as Finance Minister Vítor Gaspar has announced his resignation. The office of Portuguese President Aníbal Cavaco Silva has said in a note that Gaspar will be replaced by Maria Luís Albuquerque - one of his deputies, with a long career in the Portuguese Treasury.  

Initially, the news sounded very much as a bolt out of the blue. That was until Jornal de Negócios published Gaspar's letter of resignation on its website. The letter reveals the following:

• Gaspar had already written to Portuguese Prime Minister Pedro Passos-Coelho in October 2012, stressing "the urgency of [his] replacement as Finance Minister."

• At the time, Gaspar had decided to quit over "a series of important events". In particular, he mentions the Constitutional Court ruling that struck down the government's plan to limit extra holiday and Christmas pay for public sector workers as unconstitutional in July 2012, and "the significant erosion of public support" for the austerity measures attached to the Portuguese bailout.

• However, Gaspar was asked to stick around a bit more - at least until the 7th review of the Portuguese bailout by the EU/IMF/ECB Troika was finalised and an extension of the bailout loan maturities was secured. Incidentally, the fact he has now been allowed to leave could be seen as a vote of confidence from the government in the strength of the Portuguese economy (although Gaspar may simply have been stepping up the pressure to be allowed to exit).

• Gaspar also points out that Portugal's consistent failure to meet its deficit and debt targets under the EU/IMF bailout agreement had "undermined [his] credibility as Finance Minister." On this point, it is probably worth reminding that, on Friday, it came out that Portugal's public deficit in the first quarter of 2013 had reached 10.6% of GDP - with the target for this year set at 5.5% of GDP.

• Interestingly, Gaspar concludes his letter by saying, "It's my firm conviction that my exit will contribute to reinforce your [Prime Minister Passos-Coelho's] leadership and the cohesion of the cabinet". This seems to suggest Gaspar may have lost faith in the reform approach taken in Portugal, and may not have been willing to push ahead with it (not least for the reasons mentioned above).

In any case, the news of Gaspar's resignation hardly comes at a great time for Portugal. As we noted in a recent briefing, the country faces some tough challenges this year:

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 

• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated. 

How much impact this will have remains to be seen, although in a country where the economic future remains uncertain, suprises such as this are hardly ever welcome. In practice, though, the approach is likely to continue in much the same vein, firstly because the EU/IMF/ECB Troika has shown little willingness to be flexible with Portugal, and secondly because Maria Luís Albuquerque has often voiced her support for the approach taken so far.

That said, it is an interesting reminder of the strains the bailout programme is putting on the Portuguese government, as it begins the difficult task of finding a way to smoothly exit from its reliance on external funding.

Another UK win on single market safeguards in financial services?

An interesting report popped up on Reuters this afternoon. According to internal documents seen by the news agency, the UK has secured another important safeguard on financial services.

Specifically, during last week’s negotiations over the controversial revision of the Markets in Financial Instruments Directive (MiFID), an agreement was reached which saw the insertion of the following clause:

“No action taken by any regulator or the European Securities and Markets Authority (ESMA) should discriminate against any member state as a venue for the provision of investment services and activities in any currency.”

This is important given the on-going dispute between the UK and the eurozone concerning the location of institutions engaging in the clearing of euro-denominated financial transactions outside of the single currency bloc.

Quick recap: the UK has launched a case against the eurozone and the ECB at the European Court of Justice after an ECB legal opinion suggested that all transactions in euros should be cleared within the eurozone. This raises questions over the City of London’s position as the financial centre of Europe, and could force trillions of euros worth of financial transactions away from the city.

Although this is a very technical issue it could be a very important one in terms of the debate about the UK’s position in Europe.

That said, we’re hesitant over getting too excited for a couple of reasons:

• Firstly, this is just a preliminary agreement between officials. The final text still needs approval from the European Parliament and EU political leaders, meaning it could well be subject to substantial revision.
• Secondly, even if it is kept in, it’s not clear whether it will be legally binding, particularly when it comes to the ECB. Since the ECB is independent and currency issues usually fall under its purview, it may retain jurisdiction and authority over this decision.

Some important caveats then, but there is no doubt this is a positive step and highlights that progress can be made if the UK explores all of its political and legal options to boost its position. The government must continue to do so.

Deliberations begin as hearings draw to a close in Karlsruhe

The hearing at the German Constitutional Court into claims against the ECB's crisis policies is now over. Day one saw verbal jousting between the two men to the left (Bundesbank President Jens Weidmann and ECB Executive Board Member Jörg Asmussen) which we covered on our live blog. Day two of the hearing was a bit more cagey and less political but possibly more revealing in terms of the Court's thinking.

Constitutional Court Judge Peter Müller kicked off by reiterating the strict rules of the game:

“it is clearly defined in which china shop the elephant of monetary policy is not allowed – monetary state financing.” 

Clemens Fuest, Research Director at the Oxford University Centre for Business Taxation, shrugged his shoulders and replied:

“If OMT is ECB’s commitment to buy state bonds to a non-defined extent, than I wouldn’t know how to prevent the contact with the china shop”  

Being slightly more direct (as might be expected), Head of the Ifo Institute Hans-Werner Sinn said that the ECB engages in “regional fiscal policy” and that the Central Bank’s OMT programme is basically “a free insurance for investors when a state goes bankrupt”.

It's clear the Court remains concerned that the ECB could overstep its mandate. President of the Court Andreas Vosskuhle suggested that the current conditions attached to the OMT, the ECB’s bond-buying programme, are on a “very abstract level” but if correctly applied “could be a good middle way…of distinguishing between monetary and fiscal policy”.

A rather diplomatic construction but conditionality is a key issue here, as we’ve pointed out. The fundamental problem is that since there is no legal documentation and the OMT has never been tapped, it is very challenging for the court to judge how strictly the conditions will be applied. They could make a value judgement over whether they trust the ESM and eurozone politicians to fully implement the conditions but this could well be beyond the scope of the legal judgements the Court is allowed to make.

As Süddeutsche Zeitung's Markus Zydra points out, there is significant ambiguity around one of Asmussen's key points - that the OMT is practically limited since it can only purchase short term bonds. This is especially true given ECB President Mario Draghi's (and other's) previous remarks that there are no ex-ante limits to the OMT. Chief economists of DZ Bank Stefan Bielmeier put it nicely saying, “there is a dual rhetoric of the ECB…[they] tell everybody what they want to hear” - exactly as we noted here.

A running theme of the coverage following day two has been the signfiicant time given to those arguing against the ECB. ECB proponents reportedly told Handelsblatt “we feel like at an away game”, given the level of opposition support. The paper even goes so far as to question the neutrality of the court's referees given the line-up of known ECB critics it had called to provide evidence at the hearing (e.g. Hans-Werner Sinn, Kai Konrad, Harald Uhlig, Franz-Christoph Zeitler, Clemens Fuest).

How the Court will rule remains to be seen. It's clear they have some serious concerns about the policies but are struggling given the hypothetical nature of the case - the OMT remains undefined and unused, so any claims against it rely on second-guessing its implementation. Ultimately, it could be a question of whether they take the ECB at its word or not. Approval of policies but with some extra constraints remains the most likely outcome.

A final ruling is due for September although many involved expect a delay until after the German Federal Elections on 22 September. In the meantime, there are already those calling for a re-match in Luxembourg.

Bernd Lucke sets out his alternative for Germany and the EU

The new German anti-euro party Alternative für Deutschland’s radically different take on the eurozone compared with the rest of the German political establishment has generated a lot of interest both inside Germany and beyond. As such it was no surprise that today’s Q&A session with AfD leader Bernd Lucke (hosted by the Bruges Group in Westminster) was packed. Here are a few key points from the event:

On the formation of AfD and its prospects 

Lucke admitted that as a young Economics professor in 1999 he supported the euro because he believed it would lead to structural reforms in Southern European countries, and because he took the ‘no bailout clause’ in the Maastricht Treaty at face value. It was the breaking of this that led him to leave the CDU and eventually establish AfD.

He also said that the German political system is structured to keep out new parties – including state subsidies for established parties - with the Greens being the only successful entrant onto the scene in recent years. However he said he was encouraged by polls suggesting AfD’s potential support could be as high as 30%, and that the key would be attracting lower educated blue collar workers in particular.

On the Eurozone

Lucke said that he had reached the conclusion that the current eurozone policy was fatally “mis-conceived” and would never work because financial markets’ fears of a sovereign default could never be squared with the kind of tough conditionality necessary to ensure that member states met their obligations with regards to structural reforms and fiscal consolidation (the failure of the fiscal pact to enforce its 3% deficit limit suggests he could have a point).

Instead, he argued that the Southern member states should leave immediately in order to allow for the devaluation of their new currencies, after which the remaining member states could decide whether to maintain a currency union between themselves or to go for a full break up.

On the UK and the EU

Lucke said that despite his opposition to the euro, he was not opposed to EU integration, adding that as a German he valued its role as a peace project. He even suggested that he was not opposed to transfers between European states per se but that the current system was flawed – for example indirect transfers via the ECB’s bond buying programmes, which happen without democratic approval. However, he added that there was much to be reformed about the EU from its overbearing bureaucracy and appetite for regulation which stifle economic growth to its undemocratic practices. He added that as such he broadly supported David Cameron’s critique, and that he valued British ‘euroscepticism’ as a positive force in ensuring better decisions being reached at the EU level.

German Constitutional Court live blog: One of the most important cases in the Court's history?

The German Constitutional Court in Karlsruhe

The German Constitutional Court’s (GCC) hearings into the legality of the ECB’s actions to combat the eurozone crisis – and specifically the OMT bond buying programme – kicked off this morning. (See here for the background). In a front page leader, FAZ describes the case as one of the “most important” in the court’s history.

Public opinion in Germany is mixed, with a Forsa poll for Handelsblatt finding that 48% of Germans hope that the Court will put a stop to the OMT, while 31% believe that the complaint against the ECB is unjustified. As we noted in our flash anaylsis on the topic yesterday, the GCC can't actually stop the ECB. At worst, it could remove Germany from the ECB's bond buying programme and probably, therefore, from the eurozone itself. (A poorly phrased poll question, then, but a very telling result nonetheless).

With Schäuble, the German Finance Minister, and the ECB's positions already well known (that OMT is within the Central bank's mandate), we can safely say that the highlight of the day will come  from the opposing side, in testimony of Bundesbank President Jens Weidmann. In terms of their specific grievances, it will be the first time we will hear a detailed, public explanation of where the Bundesbank stands on this issue, while the tone of Weidmann's comments will also be interesting. Will there be any more Faust references we wonder?

Check our twitter feed for live updates from Karlsruhe throughout the day. We will also continue to update this blog as things develop.

17:45

Bundesbank President Jens Weidmann has now had his say - and again his points were very much as expected (his full statement is here but only in German for now).

• Warned that ECB OMT blurs the line between monetary and fiscal policy - this makes it more difficult to achieve price stability and spreads solvency risks amongst eurozone countries, but does so without any parliamentary or democratic approval.
• Pushed for a narrow interpretation of a central bank's primary mandate, with a complete focus on price stability.
• Suggested that the OMT does represent potential losses for taxpayers, arguing that if the ECB took on significant amounts of risky debt, it may face large a loss which it cannot absorb and may require aid from member states.
• Argued that even secondary market purchases can overturn the force of market discipline and undermine fiscal autonomy.
• Issued a warning over the interpretation of the real-risk premiums for bonds, which he suggested was very subjective and dependent on future policies.
• Accepted that the inflation outlook in the eurozone fits with price stability at the moment, but still expressed serious concern about comprising the ECB’s focus on this.

It seems to us that, of the two sides, Weidmann had the tougher case to make. Ultimately, as much of the above shows, he is forced to consider hypothetical scenarios and potential worst cases. These are undoubtedly risks that should be highlighted, but it does leave one feeling that his argument is slightly less clear cut than Asmussen’s.

Having heard the key testimony of both sides, we still expect the court to side with the ECB, but with some caveats (although how strict they will be is very much up in the air). Of course, this could still develop more tomorrow. 

16:20

Asmussen has now concluded his testimony and subsequent Q&A, and the ECB has also helpfully put a transcript on their website. Here are the key points he made:

• the OMT will have the ability to sell bonds as well as buy them, and it will not take them off the market permanently, unlike its forerunner the SMP (in fact Asmussen repeatedly highlighted the differences between the two);
• the OMT is pari passu (equal to) other creditors,
• the OMT seeks only to reduce unwarranted interest rate spikes and is not aimed at harmonising financing conditions of member states,
• the ECB would react if a country were to try to game the system by converting all its bond issues to a short maturity (of up to three years), but that in any case markets themselves would "see through and deny" such attempts,
• the only risks associated with the programme stem from countries operating "un-sound" policies, but that those states that fail to comply with the OMT's conditionality could be faced with the prospect of having to leave the eurozone.

The comments were more or less as expected. However, there are a couple of interesting points. First, the fact that the bonds purchased under the OMT will be judged at market value suggests that, if they are purchased and then decline in value, the ECB could be facing losses on its balance sheet. A tricky technical and political issue. Second, the point about 'un-sound' policies leaves us feeling slightly uneasy. Its clear that even with an ESM bailout programme, implementation may not be up-to-scratch. Meanwhile, it also highlights the clear link that would be established between ECB policies and the fiscal (and other) policy of national governments. This surely raises questions about the ECB's independence.

Asmussen also admitted that the policy did have de-facto practical limits given that it will only purchase short term debt, as reported over the weekend.

15:10

Handeslblatt reports that Philip Rösler, the German Minister for Trade and Vice Chancellor is coming under increasing pressure from his own FDP party to take a stand against the ECB, following the Handelsblatt/Forsa poll showing that almost 50% of Germans hope that Karlsruhe will stop the ECB’s OMT programme (despite this actual course of action not being possible, see blog intro above on this).

Frank Schäffler, the financial expert of the FDP parliamentary group, told Handelsblatt Online that "Working towards a market-economy is widespread among the followers of the FDP. Liberals know that prosperity cannot be printed from the ECB.”

The irony of clinging on to central bank independence, while using political pressure to change the course of the ECB is not lost on us - nor on Rösler it seems, who said: “We must not allow this course toward stability to be broken up through the the attempt to exert influence on the European Central Bank.”

13:55

These comments from ECB Executive Board member Yves Mersch seem to confirm our feelings that the ECB is trying to have it both ways over its refusal to publish the OMT documentation (see 13:30):

Mersch: "controlled uncertainty on the OMT is necessary"
— zerohedge (@zerohedge) June 11, 2013

13:40

Germany's new anti-euro party Alternative für Deutschland has just put out a press release citing Professor Joachim Starbatty - one of the original plaintiffs in the case and now one of AfD's top candidates in September's elections - warning that under the OMT, German taxpayers will be responsible for liabilities that are "no longer the responsibility of any government or parliament". The party is clearly hoping the publicity around the hearings will boost its poll ratings.

13:30

Asmussen is clearly channelling Draghi in his comments below. The ECB's continuing refusal to simply publish the legal documents relating to the OMT is at best strange and at worst downright obstructive. It does beg the question: what are they trying to hide? Maybe nothing, but at the very least it seems they are trying to have the best of both worlds. By refusing to reveal the exact terms and conditions, the ECB can try to address German concerns over the extent of the OMT (as we have seen them doing in the run up to this case) while also being able to continuously reassure markets that the scheme is in fact "unlimited".

Such a balancing act is tough to pull off and may add to confusion if it breaks down. Some transparency would be welcomed. It needs to happen at some point, who's to say it would be better revealing the legal documentation just when the OMT is being tapped, surely by definition that would be a period of crisis?

13:05

The ECB's Jörg Asmussen is up now making the point that the ECB would actually adopt a legal ordinance before any bonds were purchased:

#ECB's Asmussen: #OMT Documentation Ready For Publication When Needed. OMT Documentation Can Be Published Within Days
— Holger Zschaepitz (@Schuldensuehner) June 11, 2013

#ECB's Asmussen: #OMT Cannot Be Activated Before Publication Of Guidelines
— Holger Zschaepitz (@Schuldensuehner) June 11, 2013

11:15

German Finance Minister Wolfgang Schäuble has spoken, and as expected, he backed the ECB:

German FinMin Schäuble: #ECB Independence Gives It Wide Scope For Decision-Making
— Holger Zschaepitz (@Schuldensuehner) June 11, 2013

Schäuble tells court government sees no evidence that the ECB has overstepped the bounds of its mandate. #karlsruhe
— Michael Steen (@michaelsteen) June 11, 2013

German finance minister Schaeuble argues the court shouldn't even be considering the OMT case, as they've no jurisdiction there. #karlsruhe
— Jeff Black (@Jeffrey_Black) June 11, 2013