Has the ECB actually moved closer to QE?

There has been a cacophony of comments from ECB members and ECB watchers over the past few days. However, the overriding view since ECB President Mario Draghi’s press conference last week is that the ECB has now moved a step closer to unconventional action such as Quantitative Easing (QE).

This is mostly down to two factors. First the following statement from Draghi’s presser:

“The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation…this statement says that all instruments that fall within the mandate, including QE [Quantitative Easing], are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

Second, the FAZ report over the weekend that the ECB has been modelling the impact of a €1 trillion per year (€80bn per month) QE programme. While it suggested that such a programme would only raise inflation by between 0.2% and 0.8% (not a significant amount given the cost), the simple fact it is being modelled has been enough to give markets hope.

We believe QE or similar measures have become a bit more likely, but mostly because the market now seems to expect action and if the ECB is to maintain its credibility it will need to do more than simply talk.

That said, while there may be ‘unanimous commitment’ to using such measures when needed, it’s still not clear what the criteria are for such action and it is even less clear that all members of the GC agree on when such action would be needed. Draghi was pushed on this on the first question during the Q&A session, however, he never provided a direct answer.

Furthermore, much of the coverage has suggested that QE is in fact closer because the ideological opposition to such a measure at the Governing Council (GC) level has crumbled - although we're not sure that such a clear unified opposition ever really existed.

With this in mind then, it’s worth once again pushing the point that, in fact many of the issues with further easing are practical, political and/or legal rather than ideological at the ECB. We have previously analysed each measure in detail, below is a summary and links to all those posts:

Quantitative Easing (purchasing government debt)
We have detailed the issues extensively here (but also here and here). Draghi has hinted of these practical issues before, highlighting that they need time to design the programme and gather more information. Beyond political opposition in Germany and the legal limits to ECB financing governments, there is a clear problem in that the purchases would need to split according to the ECB capital key, meaning little would flow to the periphery where the deflationary forces are strongest. Add onto this the fact that QE in other countries has not been proven to boost the real economy or even bank lending as well as that it may exacerbate the squeeze on safe assets and it becomes clear that practically and technically this would be a very difficult step for the ECB to take and is not well suited to tackling the problem of low inflation.

Quantitative Easing (purchasing private assets)
See our detailed analysis here. The thrust would be to target purchases of assets which would help promote bank lending – the main one discussed is Asset Backed Securities (ABS), particularly ones made up of loans to the real economy. However, these markets in Europe are small and underdeveloped meaning the level of assets available and suitable for purchase would be minimal. The ECB has suggested it wants this market to grow but it’s tough to force such a move, especially in the short term.

Negative deposit rate
We analysed this option here. Since then the ECB seems to have made progress on the technical implementation of such a move. That said, the impact remains very uncertain. It could further reduce excess liquidity, force money market funds to shutter and force banks to pass costs onto consumers. On the plus side it could help weaken the euro.

A targeted LTRO (similar the Bank of England’s Funding for Lending Scheme)
Discussed, with other measures, here. A fairly simply option to take, however, given that there is already full allotment (unlimited liquidity at low rates) and banks have already repaid a lot of the previous LTROs there is no guarantee there would be any significant take up or that it would filter through to the full economy.

Ending sterilisation of the Securities Markets Programme (SMP)
A smaller measure, discussed in this post. While it would stop liquidity being drawn out of the system on a weekly basis, it’s not clear that this liquidity would flow to the real economy.

Further standard measures such as rate cuts and changing collateral rules
We rounded up such options a while ago here. Given that rates are already so low and that the transmission mechanism remains broken, the impact of such moves is likely to be limited to signalling intent rather than hoping for any significant return.

Overall, nearly all of these measures face quite serious practical, technical and/or legal obstacles.

Furthermore, it is unlikely that there is any consensus at the ECB GC level of when each measure is needed or what the triggers for such action are. The obstacles are also probably viewed to be different sizes by each national central bank. All that is to say, while it may have moved slightly closer, don't yet count on QE being much more than a last resort.

German Constitutional Court believes ECB bond buying is illegal, but asks ECJ to rule first

Hanging up their robes? Ball is now in ECJ's court

As has been widely reported this morning there has been some surprising news out of Karlsruhe with regards to the ECB's bond  buying programme and its legality.

Our full take is here, with the summary below:

Summary: The German Constitutional Court (GCC) – Bundesverfassungsgericht – has referred several questions surrounding the ECB’s Outright Monetary Transactions (OMT) programme to the European Court of Justice (ECJ). It is evident that the Court believes the OMT is illegal and incompatible with EU and, therefore, German law. However, the Court only has jurisdiction to rule on matters of German domestic law. It therefore argues that it must refer the key questions to the ECJ – the body which interprets EU law – given that the ECB’s mandate and any overstepping of EU treaties is obviously a question about EU law.

The ECJ is likely to side with the EU institutions and rule that the OMT is compatible with EU law, with the GCC likely to therefore say its hands are tied. Still, the decision throws new uncertainty into the fragile eurozone economy and could hamper the recovery. The GCC may also, in its interpretation of the OMT’s compatibility with German law, insist in new red lines - potentially limiting the level of purchases. This itself would severely restrict the role of the ECB. 

Markets, while briefly spooked, seem to have broadly recovered, whilee the euro remains slightly weaker. This doesn't seem to have had much impact, with many coming round to the view that the OMT will remain practically usable until the ECJ almost inevitably fully approves it.

The broader fallout is interesting, as this case has often been cited as one of the remaining risks in the eurozone. Despite the GCC's strong objections to the OMT, this could end up actually bolstering the ECB's position.

More generally as well, it does raise questions about Germany's role in monetary policy and the GCC's role. On EU related issues it is ultimately bound by the ECJ's interpretation of EU law. Furthermore, we can't help but feel that the Court has tried to somewhat dodge this very difficult and politically sensitive decision. It also suggests Germany may be struggling to fulling impose its will over monetary policy - although it clearly remains very powerful and many would argue continues to hold action such as asset purchases at bay.

Nonetheless, plenty of food for thought and an interesting shift in the dynamic of the eurozone.

Are further falls in inflation putting more pressure on the ECB to act?

Friday saw the release of the flash estimate for annual inflation in the eurozone in January. It dropped further to 0.7% - well below the ECB’s target of 2%.

The initial reaction was that this will increase pressure on the ECB for action at this Thursday’s Governing Council meeting. While that is true on the surface its worth keeping another couple of points in mind.

• As the graph above shows (click to enlarge), much of the recent decline has come from changes in energy and food prices. Core inflation, excluding these two factors, has been relatively stable since October and has been on a gradual decline since spring 2013.
• Now of course, many will point out that energy and food are important components of real world costs and therefore should not be discounted. This is a valid point, but here we are looking for insight into how the ECB takes its decisions. Generally, the ECB will be less concerned over short term moves in energy and food prices and is therefore less likely to take action off the back of this.
• The main part of the decline took place last year and has been happening for some time – this is likely already accounted for in the ECB easing efforts.
• While the inflation data may not push the ECB to act, there are plenty of other concerns. The turmoil in Emerging Markets could push the ECB to provide an additional liquidity buffer against any shocks. While this morning’s PMI manufacturing data was actually very positive for the eurozone, data on lending to the real economy and growth of the money supply is less so.

As we have suggested before, some further easing is looking likely. The real question is when and how? The data suggests to us that the ECB will wait until its March meeting and its updated inflation forecasts to make a judgement – but then again it went a month earlier than expected in November.

As for how, the most likely tools remain some form of targeted LTRO and/or purchases of bank loans but both programmes would require significant work and have numerous shortcomings, as we have already noted.

A peek inside the ECB’s toolkit

Despite being barely a month into 2014, there have already been countless column inches written about the ECB and President Mario Draghi’s potential actions during 2014 (mostly to tackle the ‘deflation ogre’).

Is the ECB toolkit empty?

As we have noted before, while the ECB has an extensive toolkit in the case of an acute crisis, it has so far struggled to find the right tool (if one exists) to help promote lending to the real economy and therefore economic growth.

The favoured policy, widely cited by commentators and mentioned by Draghi previously, is some form of targeted liquidity scheme linked to lending to the real economy – along the lines of the Bank of England's 'Funding for Lending' scheme.

Such an option remains possible, but as Bundesbank Chief Jens Weidmann has pointed out, difficult to implement. We have noted this before, but, given that the ECB is already running unlimited liquidity at near zero interest rates (on loans up to three months) it’s hard to see that there would be huge demand for longer loans tied to specific lending requirements.

Over the weekend, speaking at the World Economic Forum in Davos, Draghi revealed another potential policy – ECB purchases of bundles of bank loans (aka. securitised bank loans or asset backed securities).

Is this a real option?

• The ECB has previously purchased covered bonds and government debt on the secondary market. Hence, securitised bank loans should be possible in theory.
• However, as Draghi himself admitted, the market for such securities remains seriously underdeveloped in the eurozone.
• The idea seems to be in its early stages, and probably requires a lot more discussion within the ECB.
• The move would likely face significant opposition within the Bundesbank, and Germany more generally. This would probably be focused on the risks involved in such asset-backed securities, which are often opaque and continue to have a negative connotation due to their role in the financial crisis.
• These are the reasons why Draghi has previously shied away from direct action in this area, instead suggesting that it is an area for the European Investment Bank (EIB) to act. There have been comments suggesting that work was underway on a joint programme, but nothing ever emerged.

Would it be effective?

• At the moment, no. The market remains significant underdeveloped. According to the Association for Financial Markets (AFME) the outstanding securitisation market is €1,545bn - only €131bn of which related to small business loans, while the very large majority of which relate to Retail Mortgage Backed Securities (RMBS) probably from the UK and Netherlands. While Draghi is probably right in his suggestion that it would develop in response to any ECB action on this front, it has a long way to go.
• Data from AFME give some flavour for the securitisation market in Europe. As the tables below show, the market remained small over the past few years, with less than a fifth of last year’s issuance relating to lending to Small and Medium-sized Enterprises (SMEs).

• Furthermore, in terms of the location of collateral, the markets remain very underdeveloped in the countries which the ECB would likely want to target. The UK and Netherlands account for a large chunk of the European market. Italy and Spain do have some market presence, but it remains small compared to the size of their economies (although this is true for the sector in general).

• The final point to note is that the structure for such securities remains opaque and undefined. Given that they are bundles of various technical products, they will always be difficult to value, and while credit rating agencies have improved their processes, questions will still be asked as to whether their ratings truly reflect the risk and value of these products.

While this option looks to be some way off then, the fact that Draghi felt the need to bring it up will likely encourage the view that the ECB will take some further action in the coming months.

Are Greek banks improving or struggling for liquidity?

Those who followed our analysis of the Greek bond buyback will remember that we warned at length that it could have some adverse effects, one of which would be to hit bank liquidity at a time when Greek banks could least afford it.

In the end Greek banks were pushed to take part by the government but their resistance (despite being reliant on the Greek Central Bank for liquidity and the eurozone for a recapitalisation) was quite telling.

In any case, data is now beginning to emerge which sheds some light on the issue but also provides plenty of questions (as always with Greece data releases are some months behind elsewhere so the latest data available is for January 2013).

Greek bank borrowing from the ECB and the Greek Central Bank (via ELA) has dropped significantly since the bond buyback at the start of December (down €21.3bn since November 2012).

 

Now, normally a sharp drop in borrowing from the ECB and ELA would be a positive thing since it suggests reduced reliance on official funding. However, in this case, we suspect that rather than improving their position, banks are actually struggling to find sufficient assets to post as collateral with the Bank of Greece to gain liquidity.

Other factors do support this argument. The Bank of Greece annual accounts show that the overall collateral pledged for central bank liquidity fell by €11.7bn in the aftermath of the bond buyback, while borrowing from the central banks fell by €7.5bn (data for January is not yet available). Furthermore, with total assets pledged for collateral still totalling €217.1bn or 50% of all bank assets in Greece it is easy to imagine that the banking sector is working under significant collateral constraints.

Are there any other potential explanations?

Well, the first would be that banks repaid their borrowings from the ECB’s Long Term Refinancing Operation (LTRO) in January. This seems very unlikely. The LTROs coincided with a period of extreme turmoil in the Greek banking sector due to the Greek debt restructuring, a period in which Greek banks could not access the ECB. Therefore, it is unlikely that Greek banks borrowed much if anything from the LTRO. Besides, if they did, it seems strange that they would give back a key source of long term funding early.

The second explanation could simply be that confidence has returned somewhat. There is some evidence to support this, not least the return of domestic deposits, which have increased by €12.1bn since November 2012. However, that still leaves a drop in central bank borrowing of €10bn which does not seem to have been filled by other sources of liquidity.

Lastly, the bank recapitalisation is being enacted, which could reduce the Greek bank demands for liquidity, although since it isn’t expected to be completed until end of April it would seem strange if the impact showed up this early on.

Overall then, there seems to be some strong evidence that the Greek bond buyback has hit the liquidity access of Greek banks, albeit not in a catastrophic way. More importantly though it has happened at a time when credit provided to the real economy continues to contract and economic growth remains some way off.

Update 16:30 13/03/13: 
@EfiEfthimiou has flagged up a good point over email. In December 2012 the ECB began accepting Greek government bonds as collateral again, this allowed banks to switch from using the more expensive ELA to standard ECB liquidity. The haircut on collateral may also be lower under standard ECB lending (we can't be certain since ELA terms are secret). This could have allowed the banks to reduce their liquidity needs and the level of collateral posted - another potential explanation then.

ECB publishes details of SMP purchases

The ECB has just released details on its holdings of government bonds bought under the Securities Markets Programme (SMP) for the first time, see table below (click to enlarge):

To be honest, the figures are much as expected – although the holdings of Greek bonds will have decreased due to a fair amount of the holdings maturing (circa €10bn over the course of the SMP). The holdings of Italian bonds are interesting, given that we knew the ECB purchased almost €145bn of Spanish and Italian bonds, it is possibly a bit surprising that the level of Italian bonds outweighs Spanish so significantly (although it does broadly match the relative size of their debt markets). Still it highlights that necessary intervention to simply keep yields in these countries to below 7% was still very sizeable.

The move is positive for the transparency of the ECB (if a little late). Let us hope this is the start of a trend rather than a one off…

Greek banks and the Greek bond buyback

Yesterday we put out a flash analysis looking at the latest Greek deal and the prospect of Greek bond buyback. One of the many issues with the deal (and the buyback in particular) which we raised was that Greek banks will find it difficult to participate without needing extra capital.

However, Greek Finance Mininster Yannis Stournaras also said yesterday (in a timely statement):

The debt buyback "doesn't mean new capital for banks, given that they have recorded these bonds at lower prices than those that will be offered."

His suggestion then, is that the Greek banks have already marked their bonds to market prices on their books, meaning that they can sell them at the low prices involved in the bond buyback without needing new capital. This may make their participation more likely, but there are plenty of other reasons why we still see it as difficult and unpredictable. (We also still question why foreign holders will be involved, particularly previous hold outs and those who are holding to maturity, see our full analysis here).

Firstly, as Kathimerini reported today, the banks themselves are not keen to be involved in the buy back. Many feel that they have already done their part in terms of taking part almost ubiquitously in the first debt restructuring. If they were to take part in the buyback, they could seek adjustments in the terms of the recapitalisation and reform – something which the EU/IMF/ECB troika is unlikely to accept.

Secondly, taking part in such a scheme would need significant approval within the banks and other financial firms. This means board level and possibly wider shareholder approval. As the restructuring earlier this year showed, this takes time, with the process dragging for months. Given the 13 December deadline to have a bond buyback plan in place (i.e. to have a firm idea of who will take part, to make sure it is worthwhile) it is not clear how many bondholders will be in place to participate.

Thirdly, and possibly most importantly, is that the banks need their holdings of bonds (around €22bn) to gain liquidity from the Emergency Liquidity Assistance (ELA) through the Greek Central Bank (GCB). Looking at the GCB balance sheet, it seems broadly that Greek banks posted €247bn in collateral to gain €123bn in liquidity, an average haircut of 50%. Given that many of these assets will be loans or securities, sovereign debt (even Greek) is unlikely to be judged any more harshly than the average. So, if the banks sold these assets for a 65% write down (as suggested) they could purchase new assets (maybe other sovereign debt) but would be able to buy less of it (as not many other assets priced at a 65% discount) meaning they would not be able to gain as much liquidity under the ELA as with current Greek bonds.

Essentially, this could harm the Greek banks liquidity position which would further constrain their lending ability and possibly prompt further deposit flight – both of which would hurt the fragile Greek economy.

All in all then, this process could still be counterproductive for Greek banks even if they do not book new losses directly and they still could be hesitant to take part voluntarily. However, that is not to say that the political pressure applied behind the scenes will not be enough to force them to voluntarily join. Ultimately, it simply highlights that this policy may deliver a small benefit with some negative side effects but is at best a way of skirting the real issue of whether the eurozone can stomach permanent fiscal transfers to Greece. This will come to the fore again soon.

Looking to the New Year?

With trouble flaring up in Greece once more and the backstop of the ECB’s bond-buying (OMT) in place, Spain has slipped off the radar slightly. It now seems likely that any request for a sovereign bailout (of one form or another) will be pushed back until the New Year.

However, interestingly, Spain returned to the debt markets this week despite having its funding costs covered this year. It successfully sold almost €5bn worth of short-term debt on Tuesday and almost €3.9bn of medium and long-term debt yesterday.

This could mean many things, not least that the Spanish government is concerned about its cash position or the potential for unexpected costs (a regional or bank bailout for example), but we’re willing to give Spain the benefit of the doubt and see it as prudent planning to get a head start in covering its funding needs next year. This comes as somewhat of a relief given that gross Spanish funding needs could run between €150bn and €200bn next year.

On a separate, and slightly less positive note, the European Commission has, in a working document, questioned why the Spanish government has, in substance, refrained from intervening in those Spanish regions which are "clearly at risk of missing their fiscal targets in 2012" - despite legislating earlier this year to give itself such power? It is an interesting question, we would hazard a guess that the Spanish government is not ready to face the political consequences of such an action.

We can’t exactly blame them on this front but it raises the question of where their threshold is and what the repercussion of such an action would be.

As per usual from Spain then, a bit of a mixed bag, but at least it seems to be planning for next year. Now if only it took a longer term approach to its banking sector and labour market reforms…

A big week for Greece - but still few answers

As we noted in our press summary today, this week is lining up to be another big one for Greece.

The Greek government faces two crucial votes in parliament – first on Wednesday to push through the latest package of structural reforms (as demanded by the EU/IMF/ECB) troika and second on Sunday to approve the latest and, according to Greek PM Antonis Samaras, the last austerity budget for next year.

Since the governing coalition was formed after the second summer elections, such votes have usually passed without much fanfare. However, this time around the Democratic Left (which holds 16 seats in parliament) has said it will not vote with the its coalition partners. Pasok (which holds 31 seats) is also facing a period of internal strife with one MP already leaving and up to five others threatening to at least vote against the government. New Democracy (127 seats) should have an easier job pulling its MPs together.

The votes should pass but the margin for error is tiny, possibly only two or three votes, notably provoking unrest amongst financial markets and other eurozone leaders. In the end, given that the end of the government would very possibly signal the end of Greece as eurozone member, the (perceived) fear factor is likely to be enough to once again push the vote through.

This clears the way for the release of the next €31.5bn tranche of bailout funds and a potential two year extension to the Greek bailout. Today’s FT notes that the extra funding for the extension is likely to come from an increase in short term debt issuance by Greece and possibly a reduction in interest rates on eurozone loans to Greece – exactly as Open Europe predicted in its recent flash analysis on the issue.

The FT article also includes a potential plan for the ECB to return profits from its purchases of Greek bonds to Greece via eurozone governments to avoid the thorny issue of the central bank directly financing a state. This sounds plausible on the surface since the returning of profits to national governments should happen naturally anyway under the ECB rules. The only issue being that this can only happen overtime as the profits accrue as the bonds are paid off, so its unlikely to be paid out in a single chunk at one time (as is needed here).

One final point on the cost of the extension. We put it at around €28.5bn, although estimates range from €15bn to €40bn. We didn’t include a delay in Greece’s return to borrowing from the markets, which is looking increasingly likely. If Greece doesn’t return to borrowing until after 2016 it could add a further €10.6bn to the cost of an extension.

So although this is a big week for Greece, even a clear government win in both votes will do little to answer questions over Greece’s future in the eurozone.

A virtual Spanish bailout?

In case you’re wondering, we not talking about a bailout on Facebook or the like.

No, we’re referring to the quite strange comments by a Spanish finance ministry official reported in the press this morning. The official reportedly stated that Spain does not see a bailout request as imminent or immediately necessary but would be comfortable making the request for a precautionary credit line in order to potentially access the ECB’s new Outright Monetary Transaction (OMT) programme. All par for the course you would say, but the comments that really caught our eye were the following, via the FT and the WSJ:

"The credit line is not fundamental, it is circumstantial…One could say it's a virtual credit line,” adding that Spain will likely not access any of the money from the ESM, while the ECB may not even have to buy any bonds. 

Let us elaborate, because this seems to amount to a bailout without any money. Essentially, the suggestion is that Spain would sign a new Memorandum of Understanding (MoU), which wouldn’t include any new reforms or conditions, allowing it access to ESM money if it ever became necessary. This would supposedly satisfy the OMT requirements allowing the ECB to intervene in the secondary market for Spanish bonds if borrowing costs for Spain once more reach unsustainable levels.

A very neat idea in theory, as with most eurozone proposals, but we have a few concerns:

• We can’t imagine the ECB or Germany would go for it. Both would likely request stricter reforms and conditions (probably rightly, as we noted recently Spanish labour market reform has some way to go), particulary since it would need approval from the Bundestag. 
• More importantly, this may fail the ECB’s conditionality requirement. Although, details on the OMT are thin on the ground, the conditionality needs to be enforceable. The conditionality comes from a MoU which is tied to the ESM financial aid. Therefore if the ESM aid is not actually being accessed the conditionality is instantly voided since it cannot be enforced by withdrawing funding (since the funding is non-existent). 
• A strange situation could arise where the ECB is then buying bonds without the ESM lending money, while no new conditions have been enforced. We’ve warned of the moral hazard and other negative impacts of this at length before. 
• If the ESM is not lending to Spain but the ECB is buying its bonds surely the MoU and conditions essentially become a direct agreement between the ECB and Spain, putting pay to the view that these actions relate to monetary policy and maintain the independence of the ECB. 
• As the ESM guidelines on precautionary loans note, they are only available to countries where there are no “bank solvency problems that would pose systemic threats to the stability of the euro area banking system.” We’re sure this will be fudged, with the eurozone suggesting the bank bailout solves any remaining provlems, although we’d maintain that €40bn is far from enough to solve the problem.
• This is not to mention that Spain has huge funding needs and will in fact need real cash injections at some point, meaning the threat of intervention will surely not be enough to hold Spain over. 

We’ll end with an interesting, if somewhat mixed, analogy from the Spanish official:

“One does not just normally drop an atomic bomb. It has to be co-ordinated and discussed. But we [Europe] are all in the same boat.” 

Quite. As we’ve previously warned the OMT and Spanish bailout needs to be carefully structured, unfortunately a 'virtual bailout' is unlikely to do the trick.

Germans vs Inflation: the battle continues

In our daily review of UK and continental press, we spotted an interesting consumer analysis survey referenced on the front page of Bild yesterday. The survey - conducted by Axel Springer AG and the Bauer Media Group - found that Germans were conservative and prudent in terms of their finances with 67.9% of respondents possessing a savings book, 57.2% setting aside a specific sum every month, with only 33.8% having a credit card.

In contrast, in 2010, 64% of the UK’s adult population had a credit card – almost double that of Germany’s. This could possibly help to explain how the German and UK debates on the eurozone pass each other by so often, especially when it comes to the role of the ECB. The view from Berlin is that the ECB ought to remain as the guardian of price stability and not engage in activist monetary policies such as bond-buying, while the view from London, Washington and indeed other European capitals is that Draghi’s recent actions mark a decisive turning point in the crisis, and that it is good that he has been able to overcome German resistance – as argued by David Laws at an Open Europe fringe event at the Lib Dem conference.

Incidentally, former ECB chief economist Otmar Issing has an interview in yesterday’s Die Welt in which he warns against the social and economic damage of unchecked inflation:

“Many people come up to me on the street. Savers are deeply insecure and they have every reason to be. [The ECB’s] monetary policy has reached its limits [it] risks losing its credibility.” 

"There is no immediate risk of inflation. However I have my doubts that the ECB will stop its immense liquidity at the correct time. If this fails, prices will rise. I do not anticipate hyperinflation. However, even an inflation rate of 4 to 5% disposes savers and creates social problems… The social partnership between employers and unions, everything depends on a reliable monetary policy. Inflation is the most anti-social policy.” 

“[Pumping more liquidity into the system] is a dangerous argument. In putting out a fire, it is also the case that more water is not always better per se. Ultimately it could turn out that the damage caused by the water exceeds the actual fire damage.” 

Speaking to the German Industry Federation (BDI) yesterday, ECB President Mario Draghi defended the ECB’s new bond-buying programme, and in an apparent swipe at German fears of inflation, that in times of crisis “we cannot always look to the past for answers”. While Bundesbank chief Jens Weidmann may have been isolated in voting against the OMT programme, he retains the backing of a huge swathe of German public opinion which is deeply rooted in the country’s culture of savings and financial prudence.

This battle is not over by any stretch of the imagination.

Merkel caught in the middle between the Bundesbank and the ECB

In her traditional news conference following the summer recess, German Chancellor Angela Merkel walked a fine line in questions about the eurozone crisis, having to maintain a delicate balancing act with regards to different elements within her governing coalition.

For starters, she has to contend with the increasingly fractious rhetoric from the CSU – the Bavarian sister party of her own CDU – on the eurozone (see here and here for examples). The latest example being Bavarian Prime Minister Horst Seehofer’s argument that the €190bn cap on German liability imposed by the German Constitutional Court in its ruling on the ESM and fiscal treaty last week should apply to the euro-rescue effort as whole, including the ECB’s new OMT bond purchasing programme. However Merkel has rejected this interpretation on the basis the two are not linked. Speaking earlier today, she told reporters that:

“If the ECB determines that monetary transmission has become difficult, then it must take measures to ensure price stability - it is not up to us to set it limits.” 

Seehofer later confirmed that “this is the only issue which we interpret somewhat differently than in Berlin”, adding that it was nonsensical for the Court to cap Germany’s liability at €190bn only for “it to be suddenly increased by many multiples through other means”.

On the other hand however, Merkel did not issue a statement of blanket support for the ECB’s actions, adding that Bundesbank President Jens Weidmann’s recent interventions – in which he has been fiercely critical of renewed ECB bond-buying were “understandable and always welcome”, a statement widely interpreted in Germany as a subtle rebuke of Finance Minister Wolfgang Schäuble’s comments in an interview with Frankfurter Allgemeinen Sonntagszeitung yesterday in which he criticised Weidmann for his public dissent, arguing that “I'm not sure that making this debate semi-public helps to build confidence in the [European] central bank.”

Merkel is in a tough position because, having invested so much in the euro-rescue, she cannot afford to oppose the ECB’s ‘big-bazooka’ strategy. At the same time however she cannot allow Weidmann – whose views are widely respected and shared by the German public – to become completely isolated for fear this would provoke a substantial domestic backlash.

How long Merkel will be able to keep her fractious coalition together on one hand while also keeping the German public – whose support for the EU and euro has hit an all-time low – onside remains to be seen, especially in the event of unforeseen developments such as Germany actually suffering direct losses on its loans to Greece and/or losses on ECB holdings of Greek debt.

Yesterday's Karlsruhe ruling: Good news for Germany and Europe?

Following yesterday’s ruling by the German Constitutional Court in which it gave the go-ahead to both the ESM and fiscal treaty, German politicians from all the main parties were tripping over-themselves to praise the Court and its ruling. Speaking in the Bundestag, Chancellor Merkel declared it “a good day for Germany and a good day for Europe” while Foreign Minister Guido Westerwelle praised “the [Court’s] wise decision in the pro-European spirit of our Constitution.” The SPD’s parliamentary leader Frank-Walter Steinmeier also welcomed ruling, in particular the additional participation rights for the Bundestag.

While some politicians - including those who had themselves lodged legal challenges - said they were disappointed, even politicians who have been among the fiercest critics of the euro-zone bailouts declared their satisfaction, with, for example, the FDP’s Frank Schäffler describing the verdict as a “victory for democracy”, claiming that with the imposition of the cap on German liability, “The ESM has lost its sharpest tooth”.

However, interestingly the German media has adopted a more sceptical tone altogether. For example, today’s Süddeutsche comments that:

“In their ruling, the judges clearly called out the risks of the euro-rescue but drew few consequences. Their reservations do not change the fact that Europe is moving together under great financial and political risks.” 

In a front page op-ed, Die Welt editor Thomas Schmidt draws in the ECB OMT bond-buying angle – something that we also cover in our analysis of the ruling - arguing that:

“The Court watches over German money and the issue of democratic legitimacy. It is clear that the ECB decision has opened the way into the bottomless transfer union in principle. It is equally clear that the legitimacy of the path towards the further deepening of European integration is poorly grounded. This must and will result in yet more legal challenges.” 

FAZ's economics editor Joachim Jahn describes the verdict as “a slap in the face of financial policymakers”, but warns that:

"With the requirement to secure a liability cap binding under international law, the judges have at least curbed the potential harm to the taxpayer… It is however questionable how much exactly the Karlsruhe order would be worth in an emergency. A protocol to the effect that Germany does not feel itself bound by alternative interpretations of the agreement is would be easy to obtain. Whether this would be considered material by the ECJ in the event Italy and Germany were to argue over reserve liabilities is by no means certain."

Last but not least to Bild Zeitung, whose chief editor Nikolas Blome argues that:

“The ECB’s [OMT] programme is perhaps well intended but not well executed. It is highly dangerous – and here the Court’s ruling changes nothing. The double whammy of the ESM and ECB is essentially so strong so as to be able to save every eurozone member. However, exactly this will lead all eurozone states into temptation: why enact painful reforms and brutal savings when it could be supposedly easier at the expense of the others, and Germany in particular?” 

The relief of Germany’s politicians is palpable, but the battle for the future of the euro – and the role of the ECB in particular – is still far from over.

Has Draghi really saved the universe?

So it continues.

During a highly anticipated press conference, ECB head Mario Draghi - the man tasked with saving the universe after eurozone leader's consistent failures - announced today that the ECB will buy 'unlimited' government debt, albeit short-term.

So the central bank that once wouldn't touch government debt with a bargepole, has now said it's willing to underwrite governments, in theory indefinitely. In fairness, we're talking short-term, sterilised bonds from countries who enter an EFSF/ESM bailout programme - so there are several catches. Still, this is a big move, which is why markets have reacted positively.

How long it'll last is, as ever, an open question. You can read our full take on the decision (and all the technical details) here. The key concerns / questions:

• Purchases of short term debt don’t tackle the rising cost for Spain and Italy of refinancing long-term debt, and may force countries to focus more short term funding, making them more susceptible to higher borrowing costs.
• Despite all the talk of conditionality, can the ECB really cut off bond purchases from a country when it is already in trouble? We doubt it, at least not without causing huge problems in the markets (which the policy is meant to avoid).
• The sterilisation (removal of the money created) is almost irrelevant given the already unlimited lending provided by the ECB.
• Although it claims to no longer be senior to other bondholders, would the ECB really take losses, meaning that it crosses the mark for directly financing governments, if push came to shove?
• With the interbank lending market still dead and buried will a few sovereign bond purchases really restore monetary policy to ‘normality’?
• These purchases tackle a symptom not a cause of the crisis, lack of competitiveness, poor growth prospects, unsustainable debt and undercapitalised banks still weigh down the struggling countries.

The markets might be buoyed, but this one will drag on for much longer.

The Eurozone’s new quick fix risks papering over much deeper cracks

In today's City AM, we argue:

With European politicians still nursing their holiday sunburns, speculation has already returned to the Eurozone crisis. Unsurprisingly, the focus is again on European Central Bank (ECB) intervention, not least because its president Mario Draghi’s commitment to “do whatever it takes” to save the euro may now require him to follow through.

The main plan being mooted is for the ECB to cap the difference in borrowing costs between stronger and weaker Eurozone nations. The logic is that growing yield spreads drive investor fear, do not represent the true strength of these economies, and threaten a self-fulfilling bond run. Germany is naturally wary.

The plan would place the ECB directly in the realm of fiscal policy and political decision-making – a dangerous and almost untenable position for an unelected, independent central bank. Bond spreads are ultimately the market’s judgement of the fiscal policy and domestic politics of each Eurozone country. Any failure or uncertainty in either area would see the level of ECB bond-buying directly influenced by national governments’ decisions. This is even more concerning given that, if borrowing costs have an effective cap, the incentive for governments to reform quickly and effectively would be severely reduced.

The oft-cited upside is that the ECB’s unlimited commitment would be enough to deter investors from challenging the ceiling on borrowing costs, meaning that the ECB may not be required to intervene much at all. But this impact may be overstated.

Take the peg between the Swiss franc and the euro, equipped with its own “unlimited” backstop from the Swiss National Bank (SNB). The SNB has had to defend the peg, causing it to accumulate reserves equal to 65 per cent of Swiss GDP. Clearly markets didn’t take the bank at its word. It’s not clear that the ECB would be any more successful, especially in the face of similar safe haven flows into northern Eurozone countries, and investors’ desire to offload risky assets at a decent price. Don’t forget that the ECB has also seen its own credibility dented over the past two years.

It’s been contended that current borrowing costs are irrational and therefore warrant ECB intervention. While yields may not accurately represent the economic fundamentals of each nation, they are a result of markets trying to price in the domestic and European political risk, as well as the structural flaws in the Eurozone. Using the ECB to try to “correct” these issues would damage the price determination mechanism in markets.

This leads us to another area of potential political controversy. The ECB would be taking a huge step towards risk and debt pooling by allowing an EU institution to redistribute problems around the Eurozone – since all Eurozone members stand behind the ECB. Such a huge decision, integral to the future of the Eurozone and Europe, should not be taken by an unelected apolitical institution.

The fact that such a decision can’t be made at the intergovernmental level is a sign that the Eurozone is not ready for such a move. Using the ECB to force the pace of integration may well backfire. It seems many have forgotten the problems caused by pushing ahead with an unfinished economic and monetary union, lacking clear political will, in the first place.

On top of all of this, such a move stands on incredibly shaky legal ground (thanks to its clearly defined statute, which stops it from financing sovereign states). It also fails to offer a solution. This is why intervention has little support in Germany.

The spreads in borrowing costs are a symptom of the crisis rather than a cause, although they have admittedly made things more difficult. However, artificially forcing them together will only paper over deeper problems. The best such a move can do is to buy time.

With the ECB already having bought Eurozone leaders two years, which were promptly wasted, we must ask whether this latest proposition is worthwhile.

There is, as of yet, no definitive answer. But the first move must be at the intergovernmental level. Until progress is made there, any move by the ECB would simply jeopardise its fundamental mandate, putting more money at risk and dragging the crisis on further, all without any clear end in sight. The ball is firmly in Eurozone leaders’ court and should stay there.