Tough love from ECB will push reforms through
OPINION:The concept of eurobonds, or a central euro-treasury, makes sense, writes OWEN CALLAN
EVENTS ON the sovereign debt markets in recent weeks on both sides of the Atlantic have shaken investor sentiment across the world, not just on government bond markets, but for equity, commodity and many other asset classes as well. Investors have ploughed into safe haven assets as a consequence, with gold, Swiss francs and German bunds the destinations of choice for markets gripped with fear.
A number of macroeconomic indicators have also started to turn significantly lower in recent months, raising the prospect of a double dip recession. It is up to the various EU institutions to work together to plot a safe course of action out of the crisis, one that began almost four years ago to the day.
Key to recent instability in the markets is a fear that the euro zone debt crisis, which has previously seen Greece, Ireland and Portugal forced to go to the EU and IMF for financial assistance, is now starting to “infect” sentiment towards Spain and Italy as well – countries with debts so large (€2.2 trillion) that any bailout of them would call into question the future of the entire euro zone project. Seemingly intractable political and economic ideology has thus far hampered efforts across the EU to put together a fully workable solution, though this may finally be changing.
Despite no significant news on either Italy or Spain recently, sovereign yields reached new highs last week, hitting close to 6.5 per cent on Friday morning, levels generally perceived to be unsustainable in the long run.
Last week’s events, which started with the messy political agreement to raise the US federal debt ceiling and ended with stock markets in freefall, have clearly woken policymakers up to the severity of investor fears over the rapidly evolving and seemingly neverending crisis, and a massive policy response now appears to be taking shape.
On Friday evening Italian prime minister Silvio Berlusconi, under direct pressure from the ECB, announced that the new economic reform package being proposed by his government would be pushed forward at an even faster pace than originally agreed, aimed at increasing growth and balancing the budget by 2013.
These initiatives were further buttressed by a decision by the ECB, following an emergency teleconference on Sunday evening, to buy Italian and Spanish government bonds in the secondary market yesterday morning. This attempt to halt the escalation of the crisis was a “reward” for Berlusconis pronouncements on Friday.
The market reaction to the ECB’s decision, as well as the G7’s pledge to “take all necessary measures” to support growth and financial stability, was substantial. Yields fell on both markets by about 70-80 basis points, towards 5.25 per cent, though equity markets, despite initially moving higher, continued to plummet yesterday afternoon.
The ECB was active in the market several times yesterday and the buying is expected to continue in coming days and months, with the bank perhaps eventually having to buy more than €100 billion in Spanish and Italian government debt. This is likely to raise concerns from the Bundesbank and other similarly minded ECB members.
Certain euro zone countries, most notably Germany, the Netherlands and Finland, fear they are secretly signing up to a fiscal transfer union where they will be forced to write blank cheques to subsidise their poorer, southern European neighbours. While this tale of the “hard-working” German paying for their less-productive Greek cousins has been used by populist German politicians to curry favour in the polls, the reality is somewhat more complex. As a result of the super-efficient German export and manufacturing sector, Germany is in fact among the bigger, if not the biggest, beneficiary of the euro zone. The move by the ECB seems to be supported by both French president Nicolas Sarkozy and German chancellor Angela Merkel, which suggests that co-operation between politicians and central bankers is high on this occasion. Behind this public facade, the political will appears to exist to create a real and sustainable solution for the problems evident in the markets.
At the very least a much higher level of fiscal co-ordination can be expected, and the concept of eurobonds, or a central euro-treasury, makes sense from a number of perspectives. Already, through the aid facilities in place for Greece, Ireland and Portugal, and now through the ECBs purchasing of Italian and Spanish sovereign debt, we have in place within the euro zone a risk-sharing mechanism, and a quasi-transfer union. Eurobonds are perhaps the next logical step to codify this development.
This will mean national governments giving up more sovereignty to the euro zone core, but we already have a monetary union in place via the ECB, while the EU Parliament and EU Commission are continuing to increase their remit and responsibility as is. A necessary part of this solution may also require the ECB to run a looser monetary policy, and accept higher levels of inflation, than they would otherwise ordinarily accept.
The route out of the euro zone debt crisis has not been pretty, as politicians continue to try to spend the least amount of political capital possible to reach their hoped-for solution.
However, the EU and the ECB are expected to continue to fight to find the necessary solutions. Their “tough love” of sustained political pressure will form part of a continuing reform process for the peripheral euro zone economies.
The Teutonic-like fiscal package endorsed by the Italian government is a sign that this is starting to work.
Churchill used to say that the US eventually does the right thing, but only after it has exhausted all the alternatives. Hopefully the same can soon be said of the euro zone, its national governments and its central bank.
Owen Callan is senior dealer at Danske Markets Ireland