The eurozone: ‘Whatever it takes’

This article on the eurozone was written for the June issue of IPE (Investment & Pensions Europe) magazine. It is more technical than usual and, given that I quote several people, the views are not entirely my own.

In July 2012, the President of the European Central Bank (ECB), Mario Draghi, gave a landmark speech on the troubled eurozone. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” he said.

The speech was welcomed by market participants. Alongside other measures announced afterwards it helped to settle what had become a profoundly jittery market. After months of muddling-through, the authorities seemed to have taken the decisive steps necessary to quell the possibility of a eurozone break-up.

Bill Street, the head of investment at State Street Global Advisors (SSGA), no doubt speaks for many when he says he saw Draghi’s commitment as a “hugely positive step”. In Street’s view the ECB President “created a very positive environment for the markets”.

However, Street also argues that the goodwill won’t last forever. Draghi’s landmark commitment created a “window of opportunity”, he says, which could “close pretty quickly from a market and volatility perspective, if the policymakers don’t adhere to their commitments”.

Fragmentation

Almost a year since “whatever it takes”, a review is timely. Before examining developments, it is worth reprising what Draghi said as well as recalling the associated policy initiatives. Then it will be possible to assess progress in relation to three key areas: fiscal, monetary and banking union.

With the benefit of hindsight, last July’s speech was relatively sanguine about fiscal policy.?At the time, Draghi said “the progress in undertaking deficit control, structural reforms has been remarkable”.

The official view was that these challenges were already being tackled. Eurozone member states signed a Fiscal Compact in March 2012 which came into effect until January 2013. The agreement created a framework for fiscal prudence by placing limits both on fiscal deficits and on levels of public debt relative to GDP.

It is also noteworthy that Draghi’s speech did not mention economic growth. Although the eurozone economy was performing poorly at the time this was viewed as a problem that?would pass.

Draghi’s main preoccupation in the summer of 2012 was what he referred to as “fragmentation”. The final, and most important, part of his speech focused on how the reassertion of national divisions was threatening the integrity of the eurozone. His most pressing concern was the banking sector.

“The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the eurozone,” he said. “Investors retreated within their national boundaries. The interbank market is not functioning.”

Another way of conceiving of the same problem is that sovereign debt and bank liabilities had become too entwined. For example, an otherwise healthy bank in a troubled eurozone member state could suffer a kind of ‘guilt by association’. Investors could withdraw capital simply because of where the bank was based. Conversely the collapse of troubled banks could also raise questions about financially sound nations.

A week after Draghi’s speech, the ECB announced its scheme for outright monetary transactions (OMT). Designed to provide official support for troubled member states, it gave the ECB the ability to buy unlimited amounts of sovereign debt in the secondary markets.

In mid-September, the European Commission adopted two proposals designed to tackle the longer-term challenge of banking union. It supported a Single Supervisory Mechanism (SSM) for banks as a first step towards full union. Later steps would include a single bank resolution mechanism and a common deposit protection scheme. If this programme were fully implemented it would create an integrated banking sector across the eurozone.

On one level, it is clear that last year’s initiatives have proved successful. The perceived risk of a eurozone breakup has receded. As a result, events that might have startled the markets last year – the disagreement over the Cyprus bailout and the uncertainty over the formation of an Italian government – have met with relative equanimity. For Cosimo Marasciulo, head of government bonds and foreign exchange at Pioneer, “from an investment perspective this is a remarkable result”.

In other respects progress is more mixed. One pressing concern is that, even according to official forecasts, the eurozone looks set to suffer a second consecutive year of economic contraction. Although financial markets have recovered the improvement has not spilled over into the real economy. Many voices are calling for more relaxed fiscal policy in selected countries to tackle the risk of a deflationary spiral.

Such calls were already apparent at the summit of EU leaders in March 2013, when France and Italy won support for a more flexible interpretation of the Fiscal Compact. Subsequently it has become widely accepted that France, Spain and even the Netherlands should be given more leeway in meeting their fiscal targets. José Manuel Barroso, the president of the European Commission, has also said in a speech that austerity has “reached its limits” – although he also emphasised the policy was fundamentally right.

Many fund managers accept that a measured loosening of fiscal policy makes sense in the current tough economic environment. For Léon Cornelissen, chief economist at Robeco, “it is clearly a positive as austerity is self-defeating”.

Similarly, for SSGA’s Bill Street, some fiscal relaxation is welcome as long as it does not go too far. “It’s not completely surprising that the fiscal tap turns on and off over these cycles,” he says. “It would be more worrying if there were a complete ideological leap.”

The degree of fiscal loosening should not be overstated. Several countries look set to meet their fiscal targets later than planned but the framework should remain intact. If this temporary leeway becomes permanent, it might not be so readily accepted in the markets. It is also notable that not all member states will either request, or be given, such room for manoeuvre. Germany seems certain to meet the fiscal targets while peripheral countries are likely to enjoy relaxation

There is broad consensus that monetary policy should be accommodative. In May, the ECB reduced its main interest rate to 0.5%. However, there is a substantial gap between the headline central bank rates and market rates. Many companies and households, especially in peripheral countries, have to pay substantially more for credit, than those in the core. In an attempt to help tackle this divergence the ECB was, at the time of writing, hinting at a scheme to bolster credit for small and medium-sized enterprises. There is also talk of additional extraordinary monetary measures but they are yet to materialise.

The ECB is generally seen as doing a good job under difficult circumstances. “The credibility of the eurozone has improved over the last few months thanks to the ECB,” says Eric Brard, global head of fixed income at Amundi.

Banes of banking union

The most fraught area remains, as it was last summer, banking union. That is because it raises the thorny issue of financial fragmentation and ultimately broader existential questions about the eurozone. The region is more than a loose association of nation states but less than a fully integrated economic bloc. As a result, it frequently has to negotiate tensions pulling it in either direction.

At present the eurozone is inching its way towards the first stage of banking union by creating a single supervisor. In the July 2014, the ECB will start directly supervising the region’s largest banks. Smaller banks will remain under the purview of national regulators, although the central bank will have overall responsibility.

One reason ECB supervision is important is because it is a pre-condition for the direct recapitalisation of banks by the European Stability Mechanism (ESM). Without it the eurozone’s permanent bailout fund, established in September 2012, will not be able to help rebuild the region’s battered banking sector – and thereby break the connection between banks and sovereigns.

However, some see the Cyprus rescue package as pointing towards a resolution of this problem. If, in the event of a bail-out, troubled banks have to accept a levy on deposits (and their senior bondholders have to accept default) this in a sense breaks the link with the sovereign. The so-called “bail-in” arrangement could, in this view, be more widely applicable.

Leigh Skene, an associate economist at Lombard Street Research, has argued that such bail-in arrangements have benefitted the stronger economies. In his view, the policy change means that bank failures can no longer bankrupt financially sound nations (unless they ignore the bail-in provisions agreed by G20 finance ministers and central bankers).?“The outlook for the sovereign debt in most countries has improved significantly, especially those with big financial sectors and/or too-big-to-fail banks,” he has written recently.

Nonetheless, the broader drive towards full banking union looks in danger of stalling. In April, the German finance minister, Wolfgang Schäuble, raised the objection that a bank resolution mechanism, the second stage of union, could require treaty change. If Germany holds to this line, it would make banking union an even more drawn-out and cumbersome process.

Part of this reluctance to go ahead with a single resolution mechanism relates to the tricky question of legacy assets. Core countries, including Germany, are anxious to avoid paying the cost of recapitalising banks that have historically got into trouble. Germany is in favour of a more integrated eurozone in principle, but feels it should not pay for the errant behaviour of others. The trickiest challenges are arguably political rather than financial or economic.

As Ulrike Guérot, a senior policy fellow at the European Council on Foreign Relations in Berlin, says: “Germany is pretty structurally asymmetric to the rest of the eurozone”. In her view there are two dimensions to this asymmetry: demographic and economic.?Germany has a high median age, so elections tend to centre on the preoccupations of the middle-aged and elderly. In particular, there is a heavy emphasis on maintaining low inflation to protect savers. The southern European countries tend to be more focused on young people and the need to curb unemployment.

In addition, Germany’s interests are closely tied to manufacturing and exports than those of the more domestically-oriented economies of France or southern Europe. This is not to single out either the Germans or the southern Europeans for blame, but rather to explain the inertia in the system: fundamental differences result in a strong temptation to muddle through, unless an imminent threat forces the parties involved into action.

There are certainly no signs of decisive action arising from the German elections in September. Robeco’s Cornelissen expresses a common view when he says the current conservative-led government is not seeking to take the country in any clear direction.

Perhaps the greatest wild card in the election is the emergence of the new party Alternative für Deutschland (Alternative for Germany). The party is calling for a phased German withdrawal from the euro in a development that would have been unthinkable a short while ago. Many doubt it will exceed the 5% threshold needed to gain seats in the Bundestag but it could gain a significant protest vote.

The most likely scenario for the eurozone is that policymakers will continue to muddle through unless forced to do otherwise. Dario Perkins, an economist at Lombard Street Research, says that for this reason anxiety could return in a new form. “I don’t think the crisis is really over,” he says. “It’s a different type of crisis now”.

On balance the eurozone’s record since last summer is uneven. Policymakers have quelled the threat of a breakup, loosened fiscal policy for some countries and attempted to make monetary policy more accommodative. They have also taken the first step towards banking union.

On the negative side, the economic downturn has proved more protracted than expected and the forces of fragmentation have not disappeared entirely. Banking union, including the attempt to divorce sovereign risk from bank liabilities, has proved tough to take to a higher level.

Draghi’s “whatever it takes” speech in July 2012 did indeed provide a window of opportunity for the eurozone. However, if the markets come to believe that not enough is being done to resist fragmentation the window could still be slammed shut.