ECB PREVIEW: 10 QUESTIONS FOR DRAGHI
Markets expect the European Central Bank (ECB) to hold its refinance rate at 0.50% and its deposit rate at 0% at its July monetary policy meeting. However, the focus will be on ECB president Mario Draghi’s post-meeting press conference; journalists certainly have plenty of ammunition to hit Draghi with.
At the June press conference Draghi welcomed the tightening in the ECB’s balance sheet, despite the fact that Eurozone inflation is undershooting the ECB’s 2% target, and the Eurozone has been entrenched in recession for the last six quarters. During the press conference, and in subsequent speeches, Draghi has reiterated his view that looser monetary policy and better confidence is expected to support economic growth in the second-half of this year – all signs suggest that he will further reinforce this view on Thursday.
The ECB will take comfort from some of the recent economic data releases. The latest purchasing managers’ surveys, for example, show that a corner has been turned in both the Spanish and Italian manufacturing sectors. Spanish manufacturing finally moved out of contractionary territory, ending a 25-month of below-50 readings, and Italian manufacturers are the most upbeat in almost two-years (albeit remaining in contractionary territory). Surprisingly, it was Germany that disappointed, with its manufacturing PMI slipping to 48.6 on weaker Chinese demand.
But the overall Eurozone manufacturing PMI index is still in contraction territory, though it is on a rising trend, and some analysts note that the European recovery is lagging among G10 nations. Other challenges are also evident. Unemployment in the Eurozone inched higher in May to 12.2%, from 12% in April (fortunately, however, it didn’t rise to another record high). And the broader composite PMI has also slipped in June.
While inflation remains below the ECB’s 2% target at 1.6%, it did come in 0.2% higher from May’s figure, and core inflation is stable at 1.2%, underscoring that inflationary pressures remain muted. While this leaves the ECB with room to loosen conventional monetary policy further, the generally encouraging momentum of economic data will be enough for the ECB to justify keeping rates on hold.
10 QUESTIONS FOR DRAGHI
We expect Draghi to give a dovish outing at the post-meeting press conference, continuing to drive home the message that ECB policy will remain accommodative and has tools to support the Eurozone’s economy.
If previous press conferences are anything to go by, then most of the market-moving will come during Draghi’s presser; journalists certainly have a wide range of issues to quiz him on. We’d like to hear Draghi respond to the following themes:
DO EVENTS IN THE PERIPHERY RISK PULLING THE EUROZONE BACK INTO CRISIS
The stench of crisis is returning in the Eurozone. With the Portuguese government on the brink of collapse, questions hanging over Greece’s next tranche of bailout cash, and continuing concerns about Cyprus, how is the ECB able to intervene in the markets to prevent a full-blown crisis from flaring up?
Portugal: After two high-profile government resignations, the prospect of an election in Portugal is on the cards, and this may threaten Portugal’s bailout deal. Although European Commission president José Manuel Barroso expects a solution in the short term, the market is not so convinced: Portugal’s 10-year government debt yields are once again being bid above 8% (at pixel time). The crisis could pose a test for the ECB’s bond buying programme, and the question is what options the ECB has, given questions about whether the OMT can be implemented.
However, some are sanguine, arguing that a new government is unlikely to endanger Portugal’s euro membership, and they would seek to continue a slightly modified adjustment programme. But with the recent experiences of Greek and Italian elections, the reform agenda may take a back seat while political issues dominate.
Greece: Unnamed European officials were quoted by Reuters this week as expressing “a general dissatisfaction with progress in Greece when it comes to reforming its public sector, such as tax and custom collection or health care services.”
There were also reports that the Troika (the ECB, IMF and European Commission) had given Greece until the end of this week to deliver a reform agenda, or face the prospect that the next €8.1bn bailout tranche may be withheld.
The European Commission denied the report on Tuesday. However, on Wednesday, Greece’s finance ministry intimated that it cannot meet targets on reforming the public sector before the Eurogroup meeting next Monday.
If indeed Greece cannot deliver on the reform agenda, what would the ECB do to contain a potential crisis? The question is even more pertinent after the mixed messages from Angela Merkel, and Eurogroup president Jereon Dijsselbloem. Speaking to German newspapers, Merkel has rejected the possibility of new write-downs on Greek debt, while giving a confusing message on whether or not the next bailout tranche may be delayed.
Meanwhile, Dijsselbloem has insisted that there is no funding gap in Greece, only an issue with rolling over the debt (Greece has €2.2bn of debt to redeem next month). The IMF has rules that outline it is only able to help bailout a nation if it remains funded for a year. If Greece does not manage to roll over its debt, and the IMF has to pull out of the bailout, how would the ECB contain the situation?
Cyprus: Cyprus recently restructured its debt (through an exchange of around €1bn of existing government bonds), which all three major ratings agencies deemed as a distressed exchange, and downgraded Cyprus’s credit ratings to selective default, or the equivalent (although S&P did raise their credit rating to CCC+ yesterday). Subsequently, the ECB temporarily suspended the eligibility of Cypriot government debt as collateral in its Eurosystem money operations.
European officials, including Mario Draghi, met with Cyprus President Nicos Anastasiades on Wednesday, to discuss the on-going implementation of the macroeconomic adjustment programme in Cyprus. The Bank of Cyprus’s balance sheet is due to be reviewed by the ECB next month. Markets will want to know when the results of the review can be expected, and when Cypriot debt is likely to be once again accepted as collateral.
IS THE ECB ANY CLOSER TO IMPLEMENTING NEGATIVE DEPOSIT RATES?
According to previous comments by Draghi, the ECB stands ready to implement negative deposit rates (on banks parking their money with the ECB overnight), although he cautioned that there are “unintended consequences” to such a move. Given the challenges that hang over credit growth in the Eurozone, how has the ECB’s position evolved?
While the central bank seems reticent to implement the policy, markets have been particularly reactive to talk of negative rates, and some suspect that Draghi could be using it to temper any rise in the value of the euro, given that the euro has been vulnerable to comments that entertain the possibility of a negative rates.
IF THE GERMAN CONSTITUTIONAL COURT RULED AGAINST OMT, IS THE ECB OUT OF CREDIBLE OPTIONS TO ULTIMATELY PREVENT EURO COLLAPSE?
In a speech in June, Draghi said “I would say that OMT is even more essential now as we see potential changes in the monetary policy stance with associated uncertainty in other jurisdictions of the integrated global economy.”
But the OMT is under threat. The German Constitutional Court’s ruling on the legality of the OMT – expected to come after the German election in September – is arguably the primary risk to the credibility of the ECB’s monetary policies. When it was announced last year, it vanquished questions about whether the euro could survive as a currency. Confidence subsequently improved, and sovereign debt yields in the Eurozone’s periphery came out of the danger zone.
If the OMT is rendered impotent by German lawmakers, what other tricks does the ECB have up its sleeve to guarantee the euro’s survival?
IS THE ECB PREPARED TO UNLEASH OUTRIGHT QUANTITATIVE EASING?
The German Suddeutsche Zeitung newspaper recently reported that the ECB is considering outright Fed-style QE, as the central bank is concerned that the German Constitutional Court’s ruling could render the ECB’s backstops as irrelevant. The ECB has denied the report, calling the article unfounded.
From a markets perspective, it would be reassuring to see that the ECB is preparing contingency plans in case German lawmakers pull the rug from under the OMT programme.
Ahead of the German election, Draghi’s comments will need to draw a fine between maintaining the ECB’s “whatever it takes” position, while reassuring Germany that it is committed to prudent monetary policy.
IS THE ECB CONSIDERING GIVING MARKETS FORWARD-GUIDANCE?
Talk aint cheap when central bankers speak. Central bankers are increasingly using ‘open-mouth’ operations to encourage the market to move in line with their policies. We’ve seen it from the Fed, the Bank of England, and this week the Reserve Bank of Australia’s governor Glenn Stevens used a speech to talk down the Aussie. Expect Draghi to use similar tactics.
We’d like to see journalists probing Draghi with regards to how far the ECB is prepared to go in terms of offering forward-guidance. Draghi is very exact and calculating in his choice of words; the expectation is that he will reiterate the ECB’s commitment to remaining accommodative, keeping rates low and liquidity on tap, but stop short of Fed-style forward guidance, where policy is attached to economic thresholds like unemployment, for example.
DOES WATERING DOWN PARTS OF THE BANKING UNION PROPOSALS ENDANGER THE SUCCESS OF THE PROJECT?
ECB board member Mersch recently said “the different elements of banking union are bound in a symbiotic way with each other,” adding that “forgetting or watering down individual parts endangers the success of the whole project.”
Despite the recent progress made on the Eurozone banking union, the project remains behind schedule. Last summer, policymakers estimated that the Single Supervisory Mechanism will be in place by the beginning of 2013 – it now looks as though it will be 2014 at the earliest. Additionally, the resolution mechanism may require a treaty change, and that is unlikely to materialise before 2015, according to some analysts.
And there are still unknowns hanging around the proposals. For example, the issue of bail-in rules, which still has some national discretion attached to it, which some feel reduces its efficacy. The key question for the long-term is whether the banking union, as it stands, will break the link between sovereign debt and national banks.
While Draghi is unlikely to comment on behalf of Eurozone policymakers, banking union has implications for the ECB. The central bank will be conducting an asset quality review of banks in 2014; willl a US-style TARP programme follow this review?
HOW CAN THE ECB SUPPORT SMEs IN A RISING RATES ENVIRONMENT?
A lack of credit growth is inhibiting investment growth, and by extension, employment conditions in Europe. Draghi has previously indicated that the ECB is considering measures to help SMEs, possibly through resurrecting the asset-backed securities market (ABS), and is examining its policy options. One of the options being considered is whether the ECB would accept ABS as collateral as part of its liquidity operations.
Given our post-crisis experience of the ABS market, the question is whether banks will be keen to invest in these assets, and whether their balance sheets are capitalised enough to justify holding more ABS.
We are already seeing funding costs rise globally after Federal Reserve chairman Ben Bernanke recently intimated that the Fed was close to considering tapering its own asset purchase programme. How will the ECB support small businesses in this environment?
At last week’s EU summit, leaders launched an investment scheme to support SME funding through the European Investment Bank (EIB), which aims to increase SME funding by 40% by 2015, and the EIB has reportedly identified €150bn of potential lending. Some have argued that ECB’s involvement in the asset backed securities (ABS) market is likely to be based on this scheme.
The question is how risks may be pooled between the EIB, ECB and member states to support lending to European SMEs, given the ECB has shied away from direct action in the ABS market.
The ECB also has the option of using its new role as banking supervisor to influence the situation. However, this will only come after it has evaluated the balance sheets of European banks. Any progress on this front is likely to be long-term focussed, and Draghi may end up throwing the onus back onto national governments, by restating that monetary policy is not a panacea to spurring economic growth.
HOW WILL THE ECB SUPPORT THE EU IN TACKLING YOUTH UNEMPLOYMENT?
German Chancellor Angela Merkel has described youth unemployment as “perhaps the most urgent European problem,” saying that the solution lies in reforms, rather than throwing money at the problem.
At last week’s EU summit, the EIB announced measures to help tackle the problem. But there is a degree of scepticism about the EU’s plans to address the eye-watering levels of youth unemployment in Europe, which stands at around 25%. Given the size of the problem, the €6bn that the EU has committed – equivalent to just 0.1% of Eurozone GDP – seems to be a mere token gesture, rather than a significant bazooka. Does the ECB have anything it could add to help?
If anything is announced on this front, keep an eye on the yields of Spanish, Italian, Portuguese, Irish and Greek government debt yields; with youth unemployment at shockingly high levels in these countries, they stand to benefit the most from any scheme.
IS THE UPCOMING GERMAN ELECTION HINDERING PROGRESS ON REFORMS?
Some have argued that the upcoming German election has hindered the pace of reform progress in Europe. While European policymakers remain focussed on banking union, the concern is that desperately needed reforms may be put on the back burner.
Draghi is likely to be questioned on this. Again, he will have to walk a fine line between not talking down the pace of progress, while keeping deflecting blame from Germany.
ARE THERE ANY RISKS THAT SENIOR EUROZONE POLICYMAKERS MAY BE NEGATIVELY IMPLICATED IN THE ITALIAN DERRIVATIVES FIASCO?
News that Italy could face a EUR8bn hit on derivatives contracts restructured during the height of the Eurozone crisis has raised questions about the role of Mario Draghi, who was director general of the Italian Treasury during the transactions.
Draghi has refused to be drawn into the episode, pointing to official statements from the Italian Treasury. However, the issue could be raised in the context of Italy in general, as markets seek clarifications about any potential ramifications.
Yogesh Chandarana squawks the markets at Live Squawk.
Follow Yogesh on twitter: @Yogi_Chan.
Follow Live Squawk on Twitter: @LiveSquawk