ECB death pact good for risk
By James Saft
(Reuters) – It may or not prove to be good policy, but the ECB’s decision to stand as effective lender of last resort is a pretty good reason for investors to take on risk.
The ECB on Thursday announced a new program to buy, under certain circumstances, unlimited amounts of euro zone bonds, a move intended to allow it to regain control over monetary policy in the euro zone’s periphery and to serve as an effective circuit breaker against sovereign financing panics.
The plan, slammed by Bundesbank chief Jens Weidmann as “tantamount to financing governments by printing banknotes,” will target 1-3 year bonds and will be sterilized, meaning that the amount of money in circulation will remain the same.
Purchases would be triggered by applications by ailing states such as Spain, which would be required to meet strict fiscal reform conditions.
The ECB has come a long way with this policy and there is a lot to make investors optimistic, if not about the euro and its long-term prospects, at least as a form of insurance against a catastrophic near-term breakup.
“By turning itself into an ‘effective backstop’ for countries that meet tight conditions on fiscal repair and pro-growth reforms, the ECB signal led today more clearly and in much more detail than before that it will not let any solvent euro member go bust. The ECB will do what it takes to preserve the euro,” economist Holger Schmieding of Berenberg Bank wrote in a note to clients.
“Over the years, global investors have learned that it does not pay to fight the Fed. Those betting on the demise of the euro may now have to realize that the ECB is as mighty as the Fed.”
The irony here is that while investors lose all of their short-term battles with the Fed, faith in it over the longer term has not been rewarded. So it very well may be with the ECB.
A central weakness of the euro zone was that the ECB would not, and perhaps could not, play the role of lender of last resort; a central bank which would, if needed, back governments to the hilt with unlimited funds. While making these purchases highly conditional is an attempt to finesse euro zone ground rules which forbid the ECB offering direct financing to member states, de facto the ECB will now play that role if states play along.
Markets reacted positively, with stocks rising and Spanish and Italian bonds rallying. That makes great sense; so long as euro zone courts or governments don’t throw up road blocks, we now can count on a reasonable amount of breathing room for states like Spain and Italy. This clearly, in and of itself, does not solve the euro zone’s structural problems, but it does on the margin make the prospect for risky assets – be they U.S. corporate bonds or European shares – that much more attractive and most importantly, that much less volatile.
What we know is that the ECB has, at very great cost, bought some time. What we don’t know is how successful this policy will ultimately be.
As policy, conditional unlimited bond buying has a peculiar but compelling logic. Investors who don’t believe pledges of reform by member states will be scared to bet against them, and those who do believe will likely take the same side of the trade as Mr. Draghi.
What is far less clear is what happens once Spain, for example, pledges reform and gets ECB support. While Spain’s cost of financing will improve, this isn’t enough, in and of itself, to solve its problems. Europe faces an extended, perhaps multi-year, recession, which will further test balance sheets and political will to stick with reforms and austerity. Will the Spanish government in late 2013, whoever that may be, really stick with whatever pledges were made in October of 2012?
Draghi said forcefully that the ECB would pull the plug on support if a country failed to keep its end of the bargain, but that is a pledge which may not stand examination. Cutting a backsliding state loose could have massive negative effects, from the breakup of the euro to the effective insolvency of the euro zone central banking system. Seems to me that puts a lot of power in the hands of a state, and gives the ECB little scope to dictate terms indefinitely.
Becoming a lender of last resort then ultimately means that the ECB enters into a death pact, a sort of mutually assured destruction, with the states it rescues, as each can bring the other down. That may make Bundesbank fears of inflation and debasement correct, even if it doesn’t make their preferred course of policy wise.
For investors it comes to the same thing; for now be more comfortable with a bit more risk but be prepared for that to change. Your main insurer is committed and owns a printing press, but death pacts can and do end badly.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns atblogs.reuters.com/james-saft)
(Editing by Walden Siew)