Friday, August 3, 2012

What did you really expect from the ECB?

I am sure you've had the same experience I've had with hand dryers in the bathrooms of some restaurants. While some chains, such as Costco, use the more modern ones, such as the Dysan, are high speed and efficient, the older ones take forever to dry your hands and don't work very well. After waiting what seems to be an eternity, you just wind up wiping your hands on your pants.

That's the gap between expectations and reality at the European Central Bank. After Mario Draghi let it be known that the ECB would "do whatever it takes to preserve the euro", the market expected that an immediate announcement of bond buying of Spanish and Italian paper would follow. Instead, the ECB is an institution that considers, thinks, deliberates and debates before taking action. When the Der Spiegel article appeared indicating that the ECB Governing Council had been caught off-guard by Draghi's remarks, it was obvious that more work needed to be done behind the scenes:
[E]xperts at the central banks of the euro zone's 17 member states had no idea what to do with the news. Draghi's remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then.
When the ECB announced yesterday that it "may undertake outright open market operations of a size adequate to reach its objective", it shouldn't have been a surprise.

Last week, Le Monde published another article that appeared hopeful for the bulls as it indicated that Hollande and Merkel would be holding a telephone conference call to discuss the plan. In their enthusiasm, the bulls missed one crucial point about timing [emphasis added]:
Même s'il faudra encore quelques jours, voire quelques semaines, pour finaliser le dispositif en question, la BCE préparerait une opération concertée avec les Etats susceptible de limiter l'envolée des taux d'intérêt de l'Espagne, mais aussi de l'Italie.
(In case you don't understand French, the article indicated that it could take several days or several weeks to deal with the issues involved of the ECB taking steps to buy Spanish and Italian debt.)

Also of interest was the ECB statement [emphasis added]:
The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.

In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.
While it gave lip service to the discussion of "policy options" to address the "high risk premia" observed in Spanish and Italian debt costs, the ECB was holding the politicians feet to the fire to enact policy reforms, i.e. fiscal consolidation, structural reform and European institution building. Translation: we'll play ball as long as you proceed with greater economic integration and the kinds of structural reforms outlined in Draghi's Grand Plan that he outlined earlier this year. The ECB statement continued with praise for "fiscal consolidation" (read: austerity), but went on to say that "structural reforms" are also essential. Draghi's term for "structural reform" is another way of saying "growth pact" for him, which really amounts to a form of internal devaluation between the North and South.
While significant progress has been achieved with fiscal consolidation over recent years, further decisive and urgent steps need to be taken to improve competitiveness. From 2009 to 2011, euro area countries, on average, reduced the deficit-to-GDP ratio by 2.3 percentage points, and the primary deficit improved by about 2½ percentage points. Fiscal adjustment in the euro area is continuing in 2012, and it is indeed crucial that efforts are maintained to restore sound fiscal positions. At the same time, structural reforms are as essential as fiscal consolidation efforts and the measures to repair the financial sector. Some progress has also been made in this area. For example, unit labour costs and current account developments have started to undergo a correction process in most of the countries strongly affected by the crisis. However, further reform measures need to be implemented swiftly and decisively. Product market reforms to foster competitiveness and the creation of efficient and flexible labour markets are preconditions for the unwinding of existing imbalances and the achievement of robust, sustainable growth. It is now crucial that Member States implement their country-specific recommendations with determination.
Bottom line: The ECB is prepared to give the politicians cover to rescue the euro, but there is a quid pro quo involved. Don't expect immediate action, but this will be the normal back-and-forth of a negotiation process that will drive the markets crazy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Unknown said...

After initially being disappointed by the lack of immediate action, the market is now becoming over-enthusiastic regarding the apparent shift in philosophy by the ECB. Although the potential steps of renouncing seniority and open-ended QE are in the right direction, as you correctly point out, those steps will only occur under the condition that countries implement fiscal consolidation and structural reform. These actions will maintain the Euro, for a time, but also practically guarantee an extended period of high unemployment and low-to-no growth. Markets will not be happy when expectations ultimately succumb to that reality.

These thoughts are presented in more detail ( and