Tuesday, July 31, 2012

ECB preview - Draghi's dilemma

Latest comments from several government leaders and Mario Draghi have increased the stakes for Thursday’s ECB meeting. The pledge to do “whatever it takes” to save the euro gave rise to speculation about imminent ground-breaking actions. With these expectations, the ECB’s balancing act between providing the bare minimum to keep the Eurozone together, while at the same time keeping maximum pressure on politicians has not become any easier.

Indicators released since the last rate-setting meeting have provided no evidence that the gradual downward slide of the Eurozone economy is quickly coming to an end. A contraction of the economy in Q2 is in the offing and with the continuous drop in sentiment indicators, a technical recession (i.e. two consecutive quarters of contraction) seems hard to avoid. At the same time, credit growth remains lacklustre and inflationary pressures are fading away very quickly, opening the door for another rate cut.

With the recent intensification of market turmoil calls on the ECB to intervene have emerged again. Awaiting the German Constitutional Court’s verdict on the ESM in September, Eurozone politicians’ hands are at least partly tied. As long as the ESM is not up and running any additional claim on the EFSF to, for example, give Spain a fully-fledged bailout could easily stretch the EFSF’s capacity to its limits. Moreover, any further decisions on Greece are highly dependent on the Troika’s next assessment which will probably only be presented in September. All of this means that ideally Eurozone politicians would like to postpone all next crucial issues and decisions until the second half of September. The only one able to buy them this time is the ECB.

Last week, Mario Draghi’s statement that “within our mandate the ECB is ready to do whatever it takes to preserve the euro and believe me: it will be enough” gave rise to speculation about imminent ECB action. Maybe even ground-breaking action like a liquidity line for the ESM, caps on bond yields or at least large scale bond purchases? Statements by the German, French and Italian government leaders that they would do everything to safeguard the euro added to speculations about big things to happen.

This speculation, in our view, might be a bit exaggerated. At this stage, a liquidity line for the ESM looks highly unlikely. Even large scale bond purchases, with or without explicit targets, should in our view not be taken for granted. It is hard to believe that the ECB is really willing to make a u-turn on its crisis strategy. Up to now, the ECB has been on a balancing act between providing the bare minimum in terms of emergency aid to calm markets, while at the same time keeping maximum pressure on Eurozone politicians to continue with austerity and reforms. Any action to substantially tackle the debt crisis would come with a high risk of inviting political complacency and moral hazard. Remember that only back in June, Draghi said denied that there was any kind of tit-for-tat. Providing unprecedented ECB action at this state would be a clear game changer and almost a down payment for governments.

After his strong statements, ECB president will have to deliver something on Thursday. Chances are high that Draghi’s definition of “whatever it takes” does not necessarily match markets’ definition. A face-saving measure would be large-scale purchases of Spanish bonds on behalf of the EFSF. For this to happen, however, the Spanish government would first need to send an official request. According to German finance minister Schaeuble an unlikely scenario. This would leave the ECB with the minimalist approach for Thursday: a bit of SMP and maybe a bit of more tailor-made credit stimulus, LTRO and possibly even a rate cut.

No comments:

Post a Comment