While a decisive week for the euro zone is looming again, with the decision of the German Constitutional Court on the compatibility of the ESM (European Stability Mechanism) with the Grundgesetz and with the Dutch legislative elections, an equally awaited event took place last Thursday: the meeting of the Governing Council of the European Central Bank (ECB). Indeed, after Mario Draghi had stated during the summer that he would do “everything necessary to save the euro”, investors were waiting to see how this declaration would be implemented in concrete actions.
The decisions of the ECB
First, the ECB decided to leave its main interest rates unchanged. The interest rate on main refinancing operations remains at 0.75%, the marginal deposit facility’s rate at 0% and the marginal lending facility’s rate at 1.5%.
Regarding inflation, it reached 2.6% in the euro zone in August. The Governing Council forecasts that it will remain above 2% this year, because of higher taxes and energy prices, before falling under this threshold next year. Let us remember that the target set by the ECB is around 2% in the medium term.
The ECB has also downgraded its forecasts on future growth in the euro area, confirming a recession for 2012 and expecting between -0.4% and 1.4% growth for 2013. Mario Draghi indicated that economic recovery would be slow and progressive. The financial troubles of several states and banks, as well as a slowing world economy, according to The Economist, are all factors weighing down on Europe’s growth.
The Central Bank also noticed the fact that loans to the private sector still grow too slowly. This does not favour economic recovery.
Finally, concerning the most eagerly awaited and probably most important decision, Mario Draghi announced that the ECB would start buying again sovereign debt (i.e. debt from euro zone states) under some conditions. This new programme is named OMT (Outright Monetary Transactions).
First, in accordance with the EU treaties, the purchasing will not take place on the primary market (i.e. the ECB won’t buy bonds directly from the states) but on the secondary market: the ECB will buy back bonds from investors who own them.
Second, governments of countries given support against the pressure from financial markets will have to respect targets (structural reforms, deficit reduction…) set in a memorandum of financial aid also signed by the European Commission and, in theory, the International Monetary Fund (IMF). Indeed, the ECB wishes that, in parallel to her buying bonds, the EFSF (temporary solidarity fund) / the ESM (the future permanent mechanism aimed at guaranteeing financial stability and solidarity and due to start in January 2013) also contribute to the rescue. Alternately, bond purchases could also happen in the framework of a “precautionary programme”, provided that the EFSF / the MES are allowed to buy bonds on the primary market.
It is also specified that only bonds with a maturity ranging from 1 to 3 years could be purchased.
Furthermore, the ECB has chosen to give up its senior creditor status (i.e. a preferential creditor’s status). This means that if a state goes bankrupt, the ECB will not have priority in partial reimbursements.
Additionally, in order to avoid an extension of the money supply (i.e. liquidities) on the market, the Central Bank will take an amount of liquidity off the market equal to the amount of purchased bonds. So, the liquidity will be “sterilized”.
Finally, guarantees of transparency have also been granted: some data will be published on a weekly basis and other data on a monthly basis.
How to assess these decisions?
Most European leaders have welcomed these announcements, especially the Spanish and Italian ones. David Cameron, the British PM, even claimed that the ECB “had never been so close” to London’s position, while Wolfgang Schäuble, the German Minister of Finance, tacitly approved the Central Bank’s decisions and blamed the German press, which was pretty critical, for seeking sensational headlines. Let us note that several German MPs are considering referring to the European Court of Justice (ECJ), in order to check if the decision to purchase government bonds on the secondary market was in accordance with the EU treaties which forbid the monetary financing of national debt.
Beyond the (sometimes passionate) reactions to the ECB’s announcements, how can we assess these decisions?
I will be short, concerning the unchanged interest rates. I think it is a good decision, because in the current situation, conventional monetary policy does not really influence the real economy. Inflation being supported by the prices of energy imports and by the introduction on new taxes on consumption, an increase in interest rates would probably barely curb it. Furthermore, a decrease in (historically low, in the euro area) interest rates would probably not prompt households and businesses to invest more (rather than saving money on their bank accounts), because of the current “climate of uncertainty”.
Let us come to the decision of buying back sovereign debt of troubled countries, on the secondary market and under some specific conditions.
The aim is to lower the spread between interest rates paid by member states of the euro zone, knowing that the spread between Italian and German 10-years bonds reached over 450 points (i.e. 4.5%) and the one between Spanish and German 10-years bonds exceeded 550 points. Since the ECB announcements, these spreads fell at around 350 points for Italy and 430 for Spain, a level that remains high but is more bearable for these countries. That way, the citizen might get the feeling that their current sacrifices slowly start to pay off. By the way, I believe that it is justified because some countries, such as Italy, face an excessively high spread, taking account of the current reforms.
Lower spreads are also necessary for a single monetary policy to exist. Indeed, the differences among member states are sometimes so huge that it gets impossible for the ECB to take a decision that “benefits” all members.
Besides, by leading to the (at least, temporary) financial stabilization in Europe, the ECB contributes to stabilizing the euro. Let us remark that despite all the negative financial news of these last weeks and months, the euro remained pretty strong, at around 1.25 US dollar / 1 euro. This proves that the euro is not in danger!
Nevertheless, this new politic of the ECB is not without risks.
First, there is a risk that benefiting countries take advantage of the lower spread to postpone vital reforms. In principle, this risk is avoided by the request that helped states respect the targets set in a memorandum of financial aid negotiated with the Troïka (European Commission, ECB and IMF). Regarding the “precautionary programme”, it must be ensured that the incentives to vote and implement structural reforms remain. According to Mario Draghi, it is the case.
Second, the involvement of the EFSF or the ESM will work only if the country that needs help has not a big economic weight, because the funds available to these two instruments are not unlimited. So, what would the ECB do if a country required help and the EFSF / the ESM were not able to provide it? On the other hand, by involving these instruments, the ECB will force the governments to act and not to rely only on the Central Bank.
Third, several critics voiced concerns that bond purchases by the ECB would lead to higher inflation. According to Mario Draghi, these risks should be avoided by the “sterilization” of the injected liquidity. The question is: how exactly will money supply be reduced? For the rest, the analysis is the same as for interest rates (see above): inflation depends partly on external factors that the ECB cannot influence. We must simply remain aware of the fact that an increased money supply now can, if too important, lead to a bubble that would burst in a few years, leading to a return to the current situation.
Fourth and last, the ECB gives up its senior debtor status, in order to avoid that investors abandon sovereign bonds bought by the ECB. But it also increases the risks of losses for the ECB. Nevertheless, I think that the advantages outweigh the risks on this point.
The ball is in the politicians’ court
As Mario Draghi stated it during his press conference, the effectiveness of ECB’s action to solve the crisis depends on governments’ action. The crisis cannot be solved solely by monetary policy; governments have to also implement structural reforms to return to balance in the budget (it is common sense!) and to gain some competitiveness (on price, quality…).
The ECB’s decision to purchase some sovereign bonds allows creating a more favourable, a more bearable environment, but the resolution of the crisis requires most of all political courage!