SH: Quickview: The ECB’s moment of destiny…

Some have speculated that the ECB may reactivate its bond-buying programme to help reduce Spanish and Italian borrowing costs.

We asked Roger Doig for his view:

The key problem the eurozone authorities need to address is the outflow of capital from Spain. This has accelerated over the last three months and once again threatens to force an accelerated deleveraging of the banking system there.

In the real economy, the lack of bank credit starves the private sector economy. Recent tax rises and local and central government spendine restrictions compound the effect, reinforcing the negative view on growth that encourages non-domestic capital providers to withdraw. The vicious cycle is thus complete. (Italian capital outflows appear to have stopped over the last three months, but this may be temporary given the government debt maturity schedule over the rest of the year).

Promising a €100 billion recapitalisation of Spain’s banks (underwritten by Spain, and maybe by other eurozone countries one day, if it has worked), and a €65 billion austerity budget, don’t appear to have made much difference. Indeed, judged by government bond yields things got worse (though why anyone is surprised that deflationary fiscal policy is received negatively is itself a surprise). Enter Draghi last Thursday promising to act under his monetary stability mandate…

So what can he do to solve the Spanish problem? I think the answer is very little.

The biggest problem is that Spain’s rating (Baa3 Neg Watch/BBB+ Neg/BBB Neg) is now too low. Significant parts of the Spanish banking system are high yield, and all Spanish cedulas have lost their AAA ratings, sharply reducing appetite for this paper. The expectation that Spain’s austerity programme will kill growth and drive the sovereign rating lower is widespread. The nondomestic

private sector is unlikely to provide primary funding to Spanish banks – on a good day we might see some short dated cedulas from Santander or BBVA, but even the €100 billion recap is unlikely to change the funding outlook because of the Spanish government bonds the Spanish banking system has bought.

Getting private sector funding into the banks is not going to be easy. At best, the ECB can provide the banks liquidity against low quality collateral, but as we’ve seen in recent months that doesn’t trigger a change in banks’ behaviour – they still look to deleverage. The ECB’s main objective will be to keep the process orderly.

Getting private sector (and sovereign wealth fund) funding to return to Spanish government debt faces the same problem – the rating is too low, and is on a negative trajectory. The ECB can reactivate the Securities Markets Programme (SMP) and buy bonos in the secondary market if it wishes, but as with previous SMP instances, it merely becomes the liquidity provider for non-domestic holders wishing to exit (and if it pushes yields down too far, domestic holders will hit their bids). Other than providing a short-term boost to secondary prices (a significant part of which has already occurred since last Thursday), the SMP does nothing to resolve the Spanish problem, while causing friction with the Bundesbank and others, and sailing close to a breach of the TFEU* Article 123 prohibition on monetary financing of governments.

There are various other options suggested for the ECB, all of which entail some form of monetisation. Its previous efforts in this direction have already caused substantial disagreements with the Bundesbank and others, and further efforts will cause the same, without solving the Spanish problem. I doubt they can push too far – at best they can buy a little time for fiscal authorities to act.

Only a troika-style programme will enable Spain to meet its government funding requirements at a ‘sustainable’ rate. And yet such a programme would exhaust the committed resources of the ESM / EFSF**, leaving nothing for Italy, should it be next. So there appears to be an impasse, with Spain apparently looking for a programme (it has already enacted the accompanying austerity policies) and Germany opposed (presumably because of the Italian angle), according to press reports last week. This discussion looks to me more important longer term than whether the ECB buys bonds in the secondary market, as Germany will have to decide whether it will expand the ESM (and with it effective debt mutualisation) or whether it will look to pursue PSI*** policies in the south. This debate hasn’t really even started.

Incidentally, despite the “we’ll do whatever it takes to save the euro” rhetoric, the current situation has little to do with the integrity of the currency. It is not as though it will disintegrate in a disorderly manner if Draghi fails to buy some Spanish debt in the secondary market. The pendulum will just swing in the direction of Spanish PSI. The key issue is whether Europe ultimately pursues debt monetisation (the south’s favoured last resort option – and of course that of the bond market) or debt restructuring (the German-favoured last resort).

I think the market is setting itself up for disappointment on Thursday. The ECB will just be buying time, and there’s no indication the fiscal authorities are ready to act. The ECB’s bluff will be called. The ECB can’t reverse the private capital outflow from Spain (indeed it is likely just to accelerate it, like with the LTRO), and Spain creates a challenge for the rest of the eurozone that everyone wanted to avoid – and one that no-one yet has the answer to.

* Treaty on the Functioning of the European Union

** European Stability Mechanism / European Financial Stability Facility

*** Private sector involvement