Draghi commits to preserving euro

“I have a clear message to deliver: within our mandate the ECB is ready to do everything necessary to preserve the euro. And believe me it will be enough.”

Mario Draghi is ECB President and his words have had a significant impact on sentiment towards the euro, Bund yields, and the Dax and CAC, and all have enjoyed a reversal of form, suggesting that there may be a change in trend. Even bigger percentage gains were registered in Spanish and Italian markets, but actually from a technical perspective, not quite sufficient to be classified as signalling a change in trend. That said, with a following wind markets may get to make this signal – although we should also recognise that the problems in Spain and Italy cannot be waved away by mere words and whilst at one level, Mr Draghi’s statement can be seen as forceful and emphatic, actually there are a number of key questions which were not addressed.

First, it is not clear whether ‘preserving the euro’ means that no country can leave the single currency and its system.

Secondly, it is not clear as to what the ECB is mandated to do and what it is not, and as a connected issue what exactly is deemed to be and in practice required to preserve the euro.

We may reasonably assume that Mr Draghi’s comments were not off the cuff and therefore will likely have been made with the cognisance, acceptance and approval of others. This suggests that there may be a combination of fiscal intervention by the European Financial Stability Facility (EFSF), and later the European Stability Mechanism (ESM), with the purchase of primary market issues in Spain and Italy, with conditionality attached. These are important points. Secondary market yields (the pricing of existing debt) are what’s generally reported, but don’t affect the actual funding costs of the state, whereas new issue in primary market directly affect how much the state has to pay to borrow, irrespective of what happens to pricing thereafter. Conditionality is also important as it addresses the issue of fiscal constraint which has been the key sticking point for those most concerned that writing cheques doesn’t address any of the fundamental underlying problems of spending more than is sustainable.

There may also be reactivation of the ECB’s Securities Markets Programme (SMP) designed to make sure that their monetary policy is being implemented more evenly across Euroland, and whereas there issues as to whether other actions are within the ECB’s mandate, this is definitely in scope.

We may also see another 25 basis point rate cut, with other policy options likely to be under discussion. Such options may include the purchase of private sector assets (covered bonds) and extension of the long-term long term refinancing operation (LTRO) facilities, with both activities designed to improve bank funding conditions and reduce the risk of disorderly deleveraging of bank balance sheets.

The affect on markets of such a co-ordinated fiscal and monetary policy approach would be materially strengthened if the Bundesbank dropped its opposition to renewal of the SMP programme. We know that talks are scheduled between Mr Draghi and Mr Weidman on this, but we may expect that the Bundesbank has deep seated reservations about the effectiveness of the fiscal compact and any conditonality attached to primary market intervention. Still, such reservations look unlikely to prevent the ECB forging ahead, so long as there is maintained pressure on Italian and Spanish politicians to keep up their reform efforts.

The challenge as to whether a country can leave the euro  resonate with US Treasury Secretary Geithner and German Finance Minister Schaeuble backing the commitment by European leaders to do everything needed to defend the euro, but failing to mention Greece. Mr Draghi did state that “the euro is irreversible”, which can be construed that there is at least a preference for all countries remaining within the single currency. Taking these factors together suggests that the ECB may be considering taking a haircut on its Greek government bond holdings and arguably this is necessary to give Greece’s new government a chance of getting its finances straight, and it’s important for investors in peripheral Euroland debt, as there has been a concern that if the ECB joins in to support debt, it is a sort of prior charge and therefore all other investors are bumped down the capital tree.

Given these developments and all the uncertainties, we can tentatively conclude that there is at least a stay of execution for the Euro and the Euroland system. But we should not anticipate that the problems are now behind us. There remain significant challenges with growth trends at best weak and fiscal arithmetic hard to balance. We will need to watch developments with care.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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