Europe pulls the wrong lever

As I said on Friday, I’ve long held the view that contagion into Italy and/or Germany would be the key driver for more definitive action from Europe. Although we’ll have to wait until Thursday (Frankfurt time) for the ECB’s executive council meeting to find out the details the rumours are already swirling.

Last Friday world market’s got very excited by the “whatever it takes” remarks from Mario Draghi, however they were connected with “within our mandate” so it is yet to be seen exactly what the ECB will deliver. Obviously there is the downside risk of disappointment. We also need to remember that German constitutional court is still deliberating over the ESM and isn’t due to make a decision until September 12.

There are a number of ideas circulating ranging from a re-instatement of the SMP, another lowering of rates and collateral rules, through to a banking licenses for the ESM. At this point in time I think that later is a stretch way too far, but adjustments to the EFSF/ESM in order for it to make primary market purchase with support from the SMP may well be in the offing, well at least mentioned anyway.

According to various sources, the French and German governments (although I will note that Schauble’s version appears very muted ) are on-board with re-newed ECB intervention while the Bundesbank is against it. The Bundesbank reaction is expected but it must be noted that Germany only holds 2 seats on the 23 seat council, in other words no matter what their opinion they can be out-voted. The Bundesbank’s influence on the Constitutional court is obviously another matter and far more important in my opinion. There also appears to be some foreign influence with Mr Geithner once again making an appearance on European shores.

There is little doubt, however, that some remedial action needs to be taken. Although Spain and Italy can technically survive for a number of years with high yields because of their long maturity schedules, the banking system is a different story. The ECB’s previous emergency program , the 3-year LTRO, facilitated a massive push of sovereign bonds onto banks balance sheets which have in turn lost value. Rising Spanish yields cause Spanish banks to weaken further which, given the dependency, also weakens the sovereign.  Higher yields also push up lending rates which is where Mario Draghi is attempting to intervene.

Intervention, however, doesn’t come without downsides. As we saw in the case of Greece the ECB claimed seniority over private sector holders at the time of default. Unless we see an explicit statement on this topic you can assume the same will be true in future interventions and this may actually force up yields over the longer term.

I mentioned on Friday the ECB’s BLS shows that the problems with monetary transmission aren’t all supply side. One of the major issues is that demand for credit continues to decline due to the on-going deterioration of economic conditions in many nations. Although the downside risks are many, we will hopefully see some concrete action in terms of monetary policy this week. That doesn’t change the fact, however, that the end goal for Europe is to implement highly deflationary fiscal policy across many dependent nations in unison.

I’m yet to understand how exactly this is supposed to work without sinking the whole ship, which is what we have been witnessing over the last 2 years.

And speaking of such things:

Political leaders in Greece have agreed on most of the austerity measures demanded by its creditors and are now eyeing pension and wage cuts to find the final 1.5 billion euros of savings still needed, a source close to the talks said on Sunday.

Greece must find savings worth 11.5 billion euros for 2013 and 2014 to satisfy its increasingly impatient lenders who are currently on a visit to Athens to evaluate the country’s progress in complying with the terms of its latest bailout.

Prime Minister Antonis Samaras’s government last week managed to draw up a list of measures to achieve those savings, but the three parties in his conservative-led administration failed to agree on them, and are to due to resume talks on Monday.

 Italian business confidence continues to fall:

Italian business confidence declined this month more than economists forecast as executives became more concerned that the country’s economic recession will deepen in coming months.

The manufacturing-sentiment index dropped to 87.1 from a revised 88.7 in June, Rome-based national statistics institute Istat said today. Economists had predicted a reading of 88.5, according to the median of 14 estimates in a Bloomberg News survey. Istat originally reported a reading for June business confidence of 88.9.

Italy’s economy shrank for a third straight quarter in the first three months of 2012 as the region’s debt crisis worsened and Prime Minister Mario Monti’s austerity measures pushed the country deeper into its fourth recession since 2001.

Spanish unemployment continues to rise:

Some 5.7 million Spaniards, equivalent to almost one in four of the workforce, are now seeking jobs, according to official figures.

The country’s unemployment rate rose to 24.6% between April and June, up from 24.4% during the previous quarter

And  Portugal receives a warning from the OECD:

The Organization for Economic Cooperation and Development warned that Portugal risks a worse-than-expected contraction this year and next as the euro-zone crisis worsens and domestic banks reduce lending.

Still, the Paris-based OECD said Portugal should continue its efforts to narrow its budget deficit to control public debt and restore investor confidence.

In a Thursday report, the OECD laid out the main challenge faced by Portugal and other troubled European economies: While austerity measures help to control budget gaps and public debt, they also contribute to economic contraction and unemployment, which in turn make fiscal targets harder to meet.

“On balance and given the need to restore confidence, the government should aim at meeting its nominal fiscal targets as long as growth does not deviate substantially from the program,” the OECD said.

The OECD expects Portugal’s economy to contract 3.2% this year and 0.9% in 2013, worse than the government’s forecast of a contraction of 3% this year and growth of 0.6% in 2013.

The OECD also expects Portugal’s public debt to rise to 114.5% of gross domestic product this year and 120.3% next, above projections from the country’s international creditors—the European Union and the International Monetary Fund.

Such a long way to go.

Comments

  1. It’s going to be an interesting week for the ECB, and the FED not to mention the PBoC.

    I’m expecting a big can kick and from a form that you’ve mentioned. In many EU sectors this won’t fix problems any time soon, but Draghi had to act.

    I don’t know if you saw this Spanish/Italian sovereign bondholders, but for me it shows why Draghi had to do something.

    http://pdf.reuters.com/pdfnews/pdfnews.asp?i=43059c3bf0e37541&u=2012_05_01_01_37_e18311aa207c471895713f0292c047d3_PRIMARY.gif

  2. Jeff KeeganMEMBER

    “Last Friday world market’s got very excited by the “whatever it takes” remarks from Mario Draghi, however they were connected with “within our mandate” so it is yet to be seen exactly what the ECB will deliver.”

    I think it was more the “believe me, it will be enough” statement which made Draghi’s comments particularly significant.

    From your previous post:
    “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” he said, adding: “believe me, it will be enough.”

    http://www.macrobusiness.com.au/2012/07/draghi-provides-temporary-relief/

    As to what caused Draghi to act at this point in time, my guess is that it was the recent dramatic rise in short-term bond yields.

    • Or perhaps they just want to make sure good news before the summer break so that they don’t get called while on holiday ….

  3. Garry Shilson-Josling

    “… that the end goal for Europe is to implement highly deflationary fiscal policy across many dependent nations in unison.”
    “I’m yet to understand how exactly this is supposed to work without sinking the whole ship, which is what we have been witnessing over the last 2 years.”

    When you figure it out, please let me know because it’s a mystery to me too.

    History will not judge these euro-area policy-makers very sympathetically.