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Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines – Bernhard Eschweiler
Silvia Quandt & Cie. AG, Merchant & Investment Banking / Schlagwort(e): Sonstiges/Sonstiges – EU ‘fire wall’ cannot replace ECB – no matter how large – ECB liquidity drive is like providing emergency medical support – Lessons from Japan: push reforms and avoid premature monetary tightening Market attention over the last 10 days has moved back to the fiscal performance in the Euro-zone periphery. A key concern is Spain, which reported a larger than expected deficit for 2011 and announced a wider deficit target for 2012. The problem is not a lack of effort, but poor economic performance. PIIGS bond spreads over German Bunds widened on average by 50 basis points. Only Portuguese spreads managed to narrow. The correction is modest given the tightening since the start of the year and is probably not the start of a new trend. Indeed, spreads stabilized over the last couple of days. Nevertheless, the fiscal jitters serve as a reminder that the Euro debt crisis is not yet resolved. Market commentators gave the extension of the ESM to EUR800 billion credit for what calmed markets at the end of last week. That may be true, but is not proof that an increased ESM will be more effective than the current EFSF. The clout of policy tools is also unlikely to be improved by liking them with lethal weapons. This can even backfire. Examples of such analogies are the famous ‘Bazooka’, first introduced by former US Treasury Secretary ‘Hank’ Paulson, and Mario Draghi’s ‘Dicke Bertha’. France’s finance minister François Baroin topped the arms race by comparing the ESM firewall with a ‘nuclear option in military planning’. The deterrent should be big enough so that speculators would not dare to attack weak Euro members. Unfortunately, the nuclear deterrent strategy does not work for the ESM. – First, the nuclear deterrent strategy is based on the premise that the firepower is sufficient to kill the enemy several times over. The upsized ESM contains only EUR500 billion of fresh funds. The rest of the funds are already committed. The money is enough to deal with problems in Greece, Ireland and Portugal, but not Spain and Italy. Even an in- crease to EUR1 trillion or more would not be enough to defend Italy and Spain in case of a market panic. Besides, further increasing the size undermines the fiscal position of the countries that contribute to the fund, undermining the overall credibility. – Second, the nuclear deterrent strategy depends critically on the premise that the arms are in position, aimed and ready to fire. The ESM, on the other hand, first has to mobilize the funds, which means raising money in the market place. That is difficult in times of market turmoil. The EFSF has had the mandate to intervene in the market for some time, but so far has failed to make a difference for these reasons. The ESM will not do better. Only the ECB can make a difference. It has unlimited firepower and can pull the trigger at any time. The German government resisted the increase of the firewall. It believes that larger firewalls are not the solution to the underlying fiscal problems. Domestic political consideration also played a role as well as the worry that larger commitments would undermine Germany’s credit rating. The final compromise was only acceptable for Germany, because the headline figure was well below the EUR1 trillion that France and others had demanded. Second, the German consent was probably tactical as the government believes that in case of a market attack the ECB would have to step in and the ESM funds would not get mobilized. Super gun, drug or just the right thing to do? Mario Draghi’s comparison of the ECB’s 3-year LTROs with the famous German WWI super gun, called ‘Dicke Bertha’, demonstrated how badly such analogies can backfire. Critics quickly pointed out that the ‘Dicke Bertha’ was ineffective and too expensive. However, comparing the liquidity operations with dangerous drugs that have lethal side effects and make addictive, as some economists argue, is also misplaced. Only history will tell how expensive or perhaps profitable the ECB liquidity operations will really be. Yet, the effectiveness should not be in doubt. The European banking system was about to collapse and with it the Euro had the ECB not stepped in. The famous Target2 balances show that banks in the periphery had failed to refinance more than EUR800 billion in the interbank market by the end of last year due to massive capital flight. Even Bundesbank President Jens Weidmann admitted in a recent newspaper article that preventing a liquidity crunch was the right thing to do. Thus and at the risk of falling into another analogy trap, the ECB’s liquidity operations should be seen as necessary life-saving emergency measures. What has to follow is a cure to fix the root cause of the illness and that is the job of the Euro-area governments and not the ECB. Two lessons from Japan A look at Japan shows the importance of reforms as well as ample monetary support. Japan’s problems are not identical with those of the Euro-area periphery. Japan has a very competitive export sector and runs a trade surplus. The fiscal situation is a mess, but the initial problem was an asset bubble and not fiscal profligacy. However, Japan faces similar deleveraging pressures and the failure to address the structural root problems and provide sufficient monetary support has pushed it into a deflationary spiral. Japan is largely a closed economy despite its strong export sector. In fact, not only does Japan prevent competition from abroad, it also prevents internal competition, which leads to structural rigidity. The government has so far failed to break these structural rigidities. Second, the government and the central bank recognized too late that easy monetary policy was needed after the asset bubble had burst. And even when monetary policy had been relaxed, the central bank tightened twice prematurely, further compounding deflationary pressures. Merkel keeps Euro periphery on reform path What does that mean for the Euro zone? First, the ECB is right to think about an exit strategy and maintain sound prudential standards for its operations. Furthermore, the ECB should work closely with governments and regulators to ensure that fundamentally insolvent institutions are recapitalized, merged or taken out of business. However, reversing the current policy stance should be approached with extreme caution. Not only Japan is a negative example. The ECB’s own decision to hike rates last spring was clearly a mistake. At the time, the ECB was too focused on current inflation figures and underestimated the economic impact of the fiscal adjustment in Europe. The current economic data from the periphery makes it unlikely that any sane central banker is thinking about tightening. March car sales in Italy, for example, were down 26.7% from a year ago. And the weakness is not just limited to the periphery. French car sales were down 23.5%. Given fiscal and even private-sector deleveraging as well as an impaired banking system, inflation is not a major risk. Yet, that thinking may change if rising oil prices lead to higher headline inflation. Against that background, the small decline in March Euro-area inflation was welcome news. Second, governments should lose no time to push through fiscal and structural reforms. Germany led by Angela Merkel sees it increasingly as its job to make sure the Euro-area periphery stays on the reform path. The German government believes strongly that only structural reforms and not stimulus programs can revive growth. The message from Berlin is becoming surprisingly blunt: ‘reform or no more money’. And indeed, there are some encouraging developments. Italy and Spain, for example, are pushing for far-reaching labor market reforms. Unions in both countries are fighting back, but the governments have remained firm. Other news from Spain is also better. After Ireland, Spain has made the most progress in reducing unit labor cost and trimming the current account deficit. Disclaimer This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 4 April 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt. Publication according to article 5 (4) no. 3 of the German Regulation concerning the analysis of financial instruments (Finanzanalyseverordnung):
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