Welcome to the ECB & Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The current ECB President, Mario Draghi has said in his latest statements that the ECB is now determined to act as lender in last resort to governments by offering the services of the ECB’s unbounded purse.  In effect, the ECB head is willing to backstop public debts to restore the effectiveness of monetary policy as the markets continue to test its’ resolve.  This could indeed bring the euro zone close to the end of the crisis.  This is part of a recent discussion by Charles Wyplosz in Welcome to the ECB (VOXEU, 30^th July).

 

By stating that preservation of the euro is an ECB obligation, he indicated that he will have no choice but “to do whatever it takes”.  This means optimism may be justified – if only because it suggests that the Eurozone has a great central banker who is both a serious economist and an astute politician.  Draghi made an implicit commitment to act as lender of last resort to Eurozone governments. 

Draghi has political cover: every single summit since 2010 has repeated – and this quite formally and explicitly – that Eurozone leaders are ready to do whatever it takes to preserve the euro.  The time to deliver is coming.  This will be a gigantic political challenge for Merkel, but in many cases she has already changed her position in front of pressing danger to the euro zone.

 

On 11 December 2011, Mr. Draghi said:  “What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.” A fiscal compact was initiated and the Treaty on Stability, Coordination and Governance in the EMU, is now under ratification. The ECB delivered starting its massive liquidity support for Eurozone banks – the LTRO (Long Term Refinancing Operation).

 

Secondly, On 31 May 2012, Mr. Draghi famously called for a banking union, pointedly noting:  "We can have a big pot of money, but if people can't touch it, it's like we don't have it."  Although the term is vague and therefore open to much watering down, the prospect of a single European bank supervisor, a long-rejected yet indispensable element of a monetary union, is now on track.

 

The latest statement signals that the ECB is now determined to act as lender in last resort to governments.  The Draghi method is becoming clear: offer the services of the ECB’s unbounded purse, but require what it takes to alleviate the moral hazard that it entails.  Put differently, Draghi is willing to backstop public debts to restore the effectiveness of monetary policy. This would indeed bring us close to the end of the crisis.  The question is can he deliver.

 

Optimism may become justified now, if indeed the ECB is in the hands of serious economists and astute politicians.  But then, Wyplosz worries that there always is a risk of reading too much in a central banker’s unavoidably cryptic statements.

 

The lesson for risk management is not just the discussion, but what is actually delivered.

For more on this follow the link: http://www.voxeu.org/article/welcome-to-the-ecb

Risks to Continued Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

French and Greek voters are rejecting austerity, forcing politicians to take the austerity debate seriously.  Voters are correct in that it is a bad idea to tighten fiscal policy when growth is so feeble as argued by Charles Wyplosz in recent VOXEU communique (14th May) The impossible hope to an end of austerity.  However, the road away from austerity is blocked by conventional policy views that debt reduction has the highest priority – often used to justify risk taking without considering potential implications.  

 

Evidence from Greece and elsewhere is that growth is disappointing and the debt-to-GDP decline is negative and deficits are “surprisingly resistant”.  The problem is that most policies take time to work, such as structural reforms that may take several years and do not provide prompt relief. 

 

It is a poor idea to tighten fiscal policy when growth is feeble or negative.  The results from budget consolidation are disappointing as the levels of gross public debt remain above earlier estimates and in some countries have increased.  European voters do not feel that the economic and personal costs have produced any significant results.  The case for fiscal consolidation remains weak when countercyclical action is required.  

 

Monetary policy has some importance as lower rates are needed, but with rates near zero any effect would be largely symbolic.  The results from quantitative easing have yet to prove its effectiveness as banks’ focus is on deleveraging.  The recent ECB liquidity facility seems largely used by banks to hoard cash rather than make new loans.  

 

Fiscal expansion remain a weak option as a number of countries have lost market access or on the verge of losing it.  Financial markets continue to clamor for growth and no austerity, but do not want to provide financing at attractive rates for growth.  Even if countries can borrow at attractive rates, can they serve as a locomotive role for growth?   

 

Wyplosz offers several ideas around the policy debate to provide some stimulus: 1) The European Investment Bank (EIB) could borrow and finance spending without adding to the members’ public debt burden; 2) The European Commission could speed up spending on infrastructure to produce some stimulus; 3) Eurobonds could be issued and collectively underwritten by member states; 4) The bonds could be made senior to existing bonds: and 5) The debt of some countries could be restructured.  The author concludes that all the policies combined would not be enough of a stimulus.  

 

The problem is holding governments to infeasible debt reductions for a couple of years that will take decades to resolve.  Otherwise, voters will continue the protest and the austerity debate will remain a “hot” political issue.  As in risk management, conventional wisdom does not always provide the best answer.   

 

For more on this follow the link: www.voxeu.org/index.php?q=node/7988

 

 

The Coming Revolt Against Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The push toward austerity as cure-all for rising debt levels resulting from the financial crisis is losing credibility with the euro zone electorate.  The elections in Greece and France have served as a shift in the electorate toward a more pro-growth view.  Charles Wyplosz discusses these issues in a recent VOXEU communique dated May 2^nd. 

 

Wyplosz argues that governments should not mix long-term growth and fiscal discipline objectives with short-term goals to contain rising debt levels.  Instead, countries should focus on a framework for fiscal policy cooperation, restructure debts, and implement fiscal discipline in the long-run.  The German view, however, is that countries with excessive debt levels should focus on deficit reduction. 

 

This recipe has produced two years of economic contraction and surging unemployment for Greece.  There is growing debate among academics and international agencies that advocacy of pro-cyclical austerity is not producing the desired results as the situation is more complicated.

 

The sovereign debt crisis implies that highly indebted countries cannot simply borrow their way out of the crisis.  Financial markets want growth as a necessary condition for deficit reduction, but this is complicated by the fact countries cannot borrow their way out of their predicament nor borrow at reasonable interest rates. 

 

Wyplosz makes five recommendations: (1) do not mix long-term growth with fiscal discipline since they should be treated as independent objectives since there is only evidence that high debt levels can stunt growth, not fiscal discipline; (2) do not create another Lisbon accord that produces another layer of regulations and bureaucrats and serves as a means for politicians to avoid making hard decisions; (3) establish a framework for fiscal policy cooperation at the Eurozone level since recent results implemented by national authorities have been sub-optimal – a fiscal framework may allow for countercyclical policies as needed; (4) authorities should implement debt restructuring ahead of the curve limiting contagion before the market imposes penalty rates and limit market access; and (5) de-emphasize  short-term deficit targets which do not have economic justification. 

 

National cooperation on long-term objectives is needed to limit potential risks.  However, these types of national agreements need to include short-term flexibility so as to any problems created by short-term market fluctuations.  The rigid structure of the infamous Stability and Growth Pact is the exact opposite of what is needed.

 

As more countries question the role of austerity and attempt to establish long-term fiscal policy cooperation and restructure debt, what kind of surprises can we expect?  Risk managers need to focus on this shift to avoid any JP Morgan Chase type of surprises.

 

For more on this, please follow the link:  www.voxeu.org/index.php?q=node/7933

 

Untitled

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Charles Wyplosz in a recent communique discusses the shift in risk from various European countries to a “de facto” implied guarantee by the ECB  (The ECB’s Trillion Euro Bet, VOXEU, Feb. 13^th.).  The amounts could be staggering as the ECB is taking enormous risk.  Currently, the ECB is holding over euro 200 billion in sovereign bonds from recent intervention and will face nearly euro 1 trillion rollover of European sovereign debt in 2012.  

 

Eurozone sovereign spreads have recently declined with the exception of Greece.  Charles Wyplosz argues that a good part of the drop in spreads is due to the perception that the ECB is “de facto” acting as the guarantor for Eurozone government debts.  The ECB leadership suggests that the decline in sovereign spreads is the result of country reforms. 

 

There is a link between bond spread contraction and the ECB’s long-term refinancing operations (LTROs).  The LTRO bought euro zone leaders time to get their act together.  Fiscal deficits are slowly declining as the sovereign debt overhang persists, the EU banking system remains undercapitalized (current estimates of euro 100 – 200 billion), and a euro-wide recapitalization facility for banks is missing.  Analysts suggest one method for crisis resolution is through the explicit guarantee of government debt. 

 

Previously, ECB officials argued this was not their mandate; it created moral hazard, exposed the system to increased financial risk and reduced politician’s incentive to make the necessary cuts.  The new ECB regime made the LTRO available to commercial banks, but does not do enough to resolve the crisis such as providing a long-term growth strategy.  Greece and Portugal will be unable to grow with their existing debt burden and this may also be the case risk for Italy and other countries as contagion takes hold.  

 

LTROs could make things more dangerous, especially if banks use LTRO cash to acquire more sovereign bonds.  Banks could borrow money from the ECB at very low rates (about 1%) and buy bonds whose yields are much higher.  A wave of sovereign default could turn these bonds into toxic assets and a trillion-euro problem.  The more the banks accumulate these bonds the riskier the situation becomes.  The problem is compounded by the fact that banks are regulated by national authorities and under pressure to increase their domestic bond holdings.

 

The ECB seems to be making a bet that the market is swayed by its recent action and provides a stable equilibrium.  Holding sovereign debt will be seen as safe and the ECB has saved the euro at a minimal cost.  However, the reversion to a stable equilibrium is not guaranteed.  Should markets conclude crucial policy actions are missing, the debt defaults will spread and Eurozone banks might fail imposing a massive cost to taxpayers and leading to further euro problems.

 

The ECB has bought time for authorities and has involved taking on enormous risks.  The lack action on long-term restructuring of the underlying euro treaty and the promotion of a long-term growth strategy could negate their action.

 

For more information on this follow the link:  http://www.voxeu.org/index.php?q=node/7617