Draghi holds

Another EU summit begins with national leaders and the EU parliament at loggerheads over the EU budget, and a long night expected:

EU leaders face tough late-night negotiations on the bloc’s 2014-20 budget Thursday under the watchful eye of a newly assertive European parliament unhappy at the prospect of major spending cuts.

In November, leaders tried and failed to narrow sharp differences and while a compromise is expected to emerge this time, there is no certainty other than that the budget talks will be long and difficult.

An agreement hinges on finding a balance between British and German-led calls for EU cuts to match the austerity of national governments, and French and Italian-led demands to ring-fence money for investment in areas that can generate jobs and growth.

The European Commission, the EU’s executive arm, initially wanted a 5.0 percent increase in member state contributions to 1.04 trillion $1.4 trillion) euros for 2014-20 but EU President Herman Van Rompuy cut that back to some 973 billion euros for the failed November summit.

As expected, given the on-going political scandal, Spain’s latest auction showed an uptick in yields. The nation sold 2029 bonds at a yield of 5.787% VS 5.555% at previous auction in January,  2018 at 4.123% VS 3.770% and 2015at 2.823% VS 2.476%.

Germany again reported good data with industrial production moving upwards in December.

German industrial production rose in December, adding to signs that Europe’s largest economy is gathering pace.

Production increased 0.3 percent from November, when it fell 0.2 percent, the Economy Ministry in Berlin said today. Economists forecast a 0.2 percent gain, according to the median of 37 estimates in a Bloomberg News survey. November output was revised down from an initially reported 0.2 percent increase. From a year earlier, production fell 1.1 percent when adjusted for working days.

The economy is rebounding from a contraction at the end of last year. Business and investor sentiment improved more than forecast in January and the unemployment rate fell to 6.8 percent, matching a two-decade low. Factory orders rose 0.8 percent in December as demand from the euro area, Germany’s biggest export market, surged 7 percent, the Economy Ministry said yesterday.

However, as we saw with the PMI data, German strength is being offset by weakness in other nations with Spain and Portugal reporting contractions of 8.5% and 7.2% YoY in December respectively. Greece also continues to report data that show the negative effects of austerity continue to ravage the country with a 16% YoY fall on the tax take in January.

The Italian scandal is also rolling on with WSJ reporting that authorities took a leaf out of Iceland’s book and supplied  MSP took with unreported loans during the financial crisis:

Monte dei Paschi di Siena SpA, the 541-year-old Italian bank at the center of a burgeoning financial scandal, was so strapped for cash in late 2011 that it negotiated a covert loan of nearly €2 billion ($2.7 billion) from the Bank of Italy even as executives were publicly describing the lender’s funding position as comfortable, according to the Bank of Italy and people familiar with the deal.

Italy’s central bank arranged the loan in October 2011 because Monte dei Paschi, Italy’s third-largest lender, was running short of liquidity and had largely exhausted its ability to keep borrowing from the European Central Bank, according to the Bank of Italy. At the time, MPS was stuck in a whirlwind of intertwined problems: digestion of a costly 2008 purchase of a rival bank and the declining value of its portfolio of Italian government bonds, which had led the bank into a scramble to back up complex structured-finance deals.

Those deals are now at the center of a criminal probe into possible market-rules violations by the bank.

Mario Draghi is potentially in the firing line as that story develops. Speaking of the President of the ECB, he announced that the central bank held rates overnight and as usual held a press conference after the decision. The opening statement and full press conference are below. I will provide some further analysis on these early next week:

ased on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. HICP inflation rates have declined further, as anticipated, and are expected to fall below 2% in the coming months. Over the policy-relevant horizon, inflationary pressures should remain contained. The underlying pace of monetary expansion continues to be subdued. Medium to longer-term inflation expectations for the euro area remain firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Overall, this allows our monetary policy stance to remain accommodative. The economic weakness in the euro area is expected to prevail in the early part of 2013. In particular, necessary balance sheet adjustments in the public and private sectors will continue to weigh on economic activity. Later in 2013 economic activity should gradually recover, supported by our accommodative monetary policy stance, the improvement in financial market confidence and reduced fragmentation, as well as a strengthening of global demand. In order to sustain confidence, it is essential for governments to reduce further both fiscal and structural imbalances and to proceed with financial sector restructuring.

With regard to the liquidity situation of banks, counterparties have so far repaid €140.6 billion of the €489.2 billion obtained in the first of the two three-year longer-term refinancing operations (LTROs) settled in December 2011 and March 2012. This reflects the improvement in financial market confidence. Repayments are provided for in the modalities of the three-year LTROs and are at the discretion of the counterparties, who must appropriately assess their funding situation, their ability to provide new loans to the economy and their resilience to shocks. We will closely monitor conditions in the money market and their potential impact on the stance of monetary policy, which will remain accommodative with the full allotment mode of liquidity provision.

Let me now explain our assessment in greater detail, starting with the economic analysis. Euro area real GDP declined by 0.1%, quarter on quarter, in the third quarter of 2012, following a contraction of 0.2% in the second quarter. Available data continue to signal further weakness in activity in the fourth quarter and at the beginning of 2013. This weakness reflects the adverse impact of low consumer and investor sentiment on domestic expenditure, as well as subdued foreign demand. However, financial market sentiment has improved and the latest survey indicators confirm earlier evidence of a stabilisation in business and consumer confidence, albeit at low levels. Later in 2013 a gradual recovery should start, with domestic demand being supported by our accommodative monetary policy stance, the improvement in financial market confidence and reduced fragmentation, and export growth benefiting from a strengthening of global demand.

The risks surrounding the economic outlook for the euro area continue to be on the downside. They relate to the possibility of weaker than expected domestic demand and exports, slow implementation of structural reforms in the euro area, as well as geopolitical issues and imbalances in major industrialised countries which could both have an impact on developments in global commodities and financial markets. These factors have the potential to dampen the ongoing improvement in confidence and thereby delay the recovery.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 2.0% in January 2013, down from 2.2% in November and December and from 2.5% in October. On the basis of current futures prices for oil, inflation rates are expected to decline further to below 2% in the coming months. Over the policy-relevant horizon, in an environment of weak economic activity in the euro area and well-anchored long-term inflation expectations, underlying price pressures should remain contained.

Risks to the outlook for price developments continue to be seen as broadly balanced over the medium term, with upside risks relating to higher administered prices and indirect taxes, as well as higher oil prices, and downside risks stemming from weaker economic activity and, more recently, the appreciation of the euro exchange rate.

Turning to the monetary analysis, the underlying pace of monetary expansion continues to be subdued. The annual growth rate of M3 decreased to 3.3% in December 2012, from 3.8% in November. Shifts from overnight deposits to short-term time deposits led to a decrease in the annual rate of growth of M1, which declined to 6.2% in December, from 6.7% in November, and outflows from marketable instruments dampened overall M3 growth. A further strengthening in the deposit base of MFIs in a number of stressed countries took place in December, in combination with further capital inflows into the euro area, both of which continued to reduce fragmentation.

The annual growth rate of loans to the private sector (adjusted for loan sales and securitisation) remained negative in December. This mainly reflected ongoing negative annual growth of loans to non-financial corporations, which was -1.3% in December after -1.5% in November. However, annual growth in MFI loans to households remained broadly unchanged at 0.7% in December. To a large extent, subdued loan dynamics reflect the current stage of the business cycle, heightened credit risk and the ongoing adjustment in the balance sheets of the financial and non-financial sectors. In line with these developments, the bank lending survey for the fourth quarter of 2012 confirms the weakness in credit demand and the continued effect of credit risk considerations on the tightening of credit standards. At the same time, the survey confirms the positive impact of Eurosystem measures on banks’ overall funding and liquidity situation. In particular, banks reported improvements across all funding categories in the fourth quarter.

In order to ensure adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential to continue strengthening the resilience of banks where needed. Decisive steps for establishing an integrated financial framework will help to accomplish this objective. The future single supervisory mechanism (SSM) is one of the main building blocks. It is a crucial move towards re-integrating the banking system.

To sum up, the economic analysis indicates that price developments should remain in line with price stability over the medium term. A cross-check with the signals from the monetary analysis confirms this picture.

As regards other policy areas, structural reforms and fiscal adjustment can complement each other, thereby improving the outlook for job creation, economic growth and debt sustainability. Past policy action is bearing fruit, in terms of both the unwinding of existing fiscal imbalances and the reduction of current account deficits. In particular, in several countries with particular adjustment needs, contained growth in unit labour costs signals greater price competitiveness and exports are performing better. Governments should build on the progress achieved in fiscal consolidation, strengthen competition in product markets and continue with labour market reforms. This would boost the euro area’s growth potential, reduce high structural unemployment and improve the adjustment capacities of the euro area countries.

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  1. Mario Draghi is potentially in the firing line as that story develops.

    He was Governor of the Bank of Italy until 31 October 2011. How could he possibly not be in the firing line?