Bold words, high expectations and market rallies. We’ve seen steps in the right direction in Europe, but the 3 features that differentiate the latest bond buying program also highlight its flaws. It’s conditional but hard to police, transparent but uncertain, and unlimited but not long-term. The vicious circle is clear; a country will only get support if its economy deteriorates to the extent they will accept onerous conditions which will cause it to sink deeper into recession. With multiple significant flaws present in current plans, enough has been done to buoy markets but more is needed to support economic progress and bring sufficient confidence back to markets.
“Whatever it takes”
With bold statements come high expectations and Draghi, the European Central Bank President, has been acutely aware of this fact. After claiming he would do “whatever it takes” to save the euro, the pressure was on to support this with a decisive plan of action.
Earlier this month he seemed to do just that, promising to launch an unlimited bond-buying program to ease pressure on sovereign borrowing costs. Taken positively by the markets, the Eurostoxx closed up over 2% that day and periphery sovereign bond yields fell on the news alone.
However, the question remains: has this really marked the end of the Eurozone crisis? The rally has taken bank shares and CDSs back to where they stood in March, when markets similarly put faith in cheap 3-year ECB loans, only to be disappointed. Are markets at risk of a correction this time too?
Step in the right direction but we’ve a long way to go
Draghi identified at least 3 ways in which his latest plan would be different from previous bond-buying schemes. However, they also help identify flaws which could come to light if the situation in the Eurozone were to continue to deteriorate significantly:
1. Conditional but hard to police
To allay (German) worries of long-lasting and repeated requests for help, the support provided by the ECB will come with conditions. The ECB will buy bonds of countries that request help, as long as they conform to certain terms. Countries will be charged with specific requirements, e.g. spending cuts, to try and build fiscal discipline so assistance can wind down. The conditional nature of any offer to support a country’s government bonds could however also be cause for concern. It is hard to police. The resultant turmoil that would ensue from a country not only having identified themselves as in need of help, but now having that help withdrawn would extend beyond the country in question. This would therefore be mutually destructive. With investors fleeing from any asset perceived to be exposed to this country as they looked to de-risk portfolios, ECB assets could be damaged, lowering their resolve to enact this punishment.
Moreover, this unintentionally maps out the road to a euro exit. It highlights that once a country that has received a bailout no longer meets specific targets, the rug may be pulled out from underneath it and the resulting pressure could force it out of the euro.
2. Transparent but uncertain
The ECB will be transparent about which country’s bonds they are buying, reducing speculation and giving markets a clearer indication of what’s going on. However, this doesn’t mean the picture would be crystal clear. Uncertainty remains as to the exact level at which bond-buying could be triggered and the conditions that would be put in place.
3. Unlimited but not long term
There is no cap on the amount of bonds that can be bought and therefore it can provide some form of support long into the future. However, this does not equate to a long term solution. Buying bonds is not a substitute for reform or a strategy for economic growth, which Draghi himself stated has “risk to the downside”. Both of which are crucial for the health of Europe and an end to the crisis.
Finally, although not corresponding to anything stated as a benefit of the plan, it was not unanimous. The German Bundesbank President was not in favour of the plan and could still cause trouble. Indeed, it has since been ruled that Germany has the right to vote over every rescue programme. Considering the country’s fondness for austerity, bailout terms could be tougher and either rejected, damage the economy further, or accepted and failed to be followed. The vicious circle is clear; a country will only get support if its economy deteriorates to the extent they will accept onerous conditions which will cause it to sink deeper into recession.
With multiple significant flaws present in current plans, enough has been done to buoy markets but more is needed to support economic progress further down the line and bring sufficient confidence back to markets.