Thursday, 26 July 2012

ECB pledges to do "whatever it takes" to preserve the Euro

Mario Draghi, president of the European Central Bank has reiterated today his commitment to the preservation of the common currency by hinting at upcoming supportive measures. Mr. Draghi said today during a conference in London that the ECB is prepared to do "whatever it takes" to keep the euro-boat afloat. The announcement sparked a relief rally in  risk assets such as the EUR/USD, the S&P500, Gold and Spanish yields. But, without hard facts, the rally will most likely be short lived.

Some context inside the European Union

The European Union is currently divided in two groups of countries: some which enjoy lilliputian yields (take the UK 10 year bond yields trades at 1.49%, down from last months` figure of 1.69%, or the German 10 year which currently yields 1.32%, the lowest yielding Euro denominated bond), or even negative yields (take the 2 year Danish bond which returns -0.26% and the Swiss 2m, 3m, 2y, 3y, 4y, and 5y which are all negative), and the riskier, "peripheral" countries, either in a murky economic and financial situation (such as the so called PIIGS: Portugal, Ireland, Italy, Greece and Spain) or in a frustratingly puerile political deadlock (say Hungary, Belgium and Romania).

It is clear that whatever bank, financial institution, individual or central bank held reserves of troubled European countries` sovereign bond has been trimming its exposure in the last few years: the Greek banking sector has seen deposit outflows of €8.5 bn in May 2012, amounting to almost 5% of its entire deposit base and Spanish banks have suffered as similar bank run: €31 bn in April, or almost 1.9% of its entire pool of deposits while the Spanish - German 10 year yield spread increased from close to the pre-crisis level of zero to 5.61%. Yield spreads of Greek, Italian, Portuguese and Irish bonds have also priced in the ever-increasing credit risk.

Some context outside the European Union

Simply put, at this stage the financial-economic crisis is a crisis of confidence: creditors have lost their appetite for risk because of the global financial uncertainty while consumers have lost their ability to finance their credit induced spending sprees. Add to this a bit of political malaise: the Chinese are set for a leadership relay, the USA is undergoing an ideological crisis between "more government" and "less government" proponents, and the outcome of the November elections between Obama and Romney is all but certain, the European union is divided between creditors and countries in need of credit, Russia, Brazil and India have their own internal issues to deal with, and the "Arab Spring" has turned Africa and the Middle East into a boiling pot of revolutionary resentment. And to add insult to injury, economists now have to advise politicians on the sustainability of the liberal capitalism vs the socialist capitalism.

A small, but bold step indeed

While Mario Draghi`s speech was full of big words like "whatever it takes", "the Euro is irreversible", "sharing sovereignty on EU level will come", as the president of the ECB he is unable to provide an operational plan with definite targets. At this point it is up to the Angela Merkel, the German chancellor to fight for, or to disapprove an EU banking union, accompanied by a fiscal union, followed by a political union. For this scenario to happen, the German constitutional court needs to approve whether troubled banks should be bailed-out by the ESM, but a ruling is unlikely to be put forth before the 12th of September. Until then the only option that the ECB has to cool off bond vigilantes is to go ahead with another round of credit tsunami, under the name of LTRO (Long Term Refinancing Operations).

While the markets today where quick to rally on these positive words, it is still unclear what EU officials will do in the upcoming months to push for more integration. After all, the creditors want more to say on a political level and the debtors want more financial concessions. Until the EU leaders figure out who will get what, the relief rally will be just a breather in a toxic environment.

Image credit The Telegraph

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