In July 2012, Mario Draghi, the European Central Bank President, pledged to do “whatever it takes” to salvage the euro and drew a line under the first and most damaging phase of the eurozone’s debt crisis, which had begun two years earlier. Next week we find out just how far he is willing to go.
Mr Draghi’s commitment shored up the debt markets of nations in danger of tumbling like dominos, but also set him on a path all but certain to culminate in a money-printing operation in eight days’ time: buying up the sovereign bonds of eurozone countries in an increasingly desperate attempt to spark growth.
As austerity measures grip, the human cost of the crisis is still painfully apparent. Eurozone unemployment remains at 11.5 per cent, or 18.4 million. Of these, 3.5 million are under 25. Today, Mr Draghi will hope to pass a key hurdle in his plans for quantitative easing (QE) when the European Court of Justice hands down its initial verdict on the legality of Outright Monetary Transactions. The OMT programme was his “big bazooka” unveiled in 2012 but never used, a tool allowing the ECB to step in to buy up the debts of individual eurozone countries in unlimited quantities if necessary.
A decision on the legality of OMT was referred to the ECJ by Germany’s constitutional court last year. The Germans – always inflation-wary – were concerned over the open-ended nature of the scheme, as well as the ECB exceeding its monetary policy remit. Mr Draghi and his rate-setting colleagues in Frankfurt are likely to have to build the court’s finding into their plans. But other questions remain over QE as the ECB prepares to warm up the printing presses and Greece prepares for a potentially traumatic election.
Mr Draghi and his colleagues are nearly six years behind the Bank of England and the US Federal Reserve in embarking on quantitative easing. But the ECB has not hit its inflation target of “close to 2 per cent” for more than two years. In December, inflation turned negative for the first time since 2009, with prices down 0.2 per cent year on year.
What is really spooking the ECB, however, is falling inflation expectations. The bank’s preferred measure of long-term inflation is the “5Y/5Y inflation swap rate” – essentially the financial market’s forecast of what eurozone inflation will be on average between 2020 and 2025. This has sunk dramatically since the autumn, from above 2 per cent to near 1.5 per cent.
This shows expectations of lower prices becoming more entrenched. Falling oil prices are a boon for consumers but means companies could defer investment decisions if they think prices will drop further: so-called “bad deflation”.
Is this the last resort?
The ECB has tried everything: cheap liquidity for the banking system, interest rates of just 0.05 per cent and negative interest rates for institutions – charging them for holding deposits at the central bank. It is also buying asset-backed securities (ABS) and covered bonds – packages of loans – in limited quantities. Full-scale QE feels like the last shot in the locker.
Debt financing is illegal under European Union treaties, but the ECB would make the argument that QE is a purely monetary tool, in line with its treaty mandate to ensure price stability.
How much will he do?
Estimates range between €500bn and €1trn. Mr Draghi has said he wants build the ECB’s balance sheet back to 2012 levels of about €3trn. The size of the balance sheet is currently €2.2trn. But eurozone banks are due to pay back about €300bn in outstanding loans under two previous refinancing operations three years ago, which flooded the eurosystem with cheap cash.
With ABS and covered bonds relatively small so far – about €70bn according to one economist – that leaves Mr Draghi needing to buy about €1trn to hit his balance sheet target.
What will he buy?
This is by far the most complex – and controversial – aspect of the operation. Mr Draghi has many options. If he taps the biggest bond markets – that of Italy for example – he runs the risk of rewarding previous profligacy and mutualising the risk across the entire eurozone, which is unlikely to go down well in Germany.
He could concentrate only on AAA-rated sovereign bonds such as Germany, Austria and much smaller Luxembourg: but the bank might have to spend more to have an effect (German bund yields are already negative) and such a policy isn’t exactly unified, making it very clear who the safe bets are.
A third option, which seems more likely, is to buy up sovereign debt according to each country’s “capital key” – the weighting of its capital at the ECB. It could also ask national central banks to take a “first loss” on bond purchases.
David Page, the senior economist at AXA Investment Managers, said: “The ECB is likely to plough a furrow between two extremes, not simply buying ultra-safe stuff to protect the balance sheet or Greek/peripheral bonds, which increases credit risk. It could go through the middle, buying German bunds as well as peripherals but hoping the asset managers who sell the bunds spend the cash on something a bit more risky.”
What about Greece?
The Greek election just three days after the ECB’s meeting and potential victory for the anti-austerity Syriza party is an “untimely curve-ball” according to Hermes chief economist Neil Williams. It seems unlikely that Mr Draghi will buy up the struggling nation’s debts in significant quantities until there is clarity over the new government’s stance. “Restructuring risk will stay on the radar,” Mr Williams said.
Will it work?
In relative terms the ECB’s €1trn is a far smaller operation– 10 per cent of GDP – than those conducted by the US Federal Reserve and the Bank of England, which has made purchases worth more than 20 per cent of GDP.
Some experts, however, believe that QE could give a shot in the arm to exporters by hastening the fall of the euro, already down 13 per cent against the dollar to below $1.18 since July last year.Reuse content