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Complex operation

30 July 2012 By Hugo Dixon

Can Super Mario save the euro? Mario Draghi said last Thursday that the European Central Bank’s job is to stop sovereign bond yields rising if these increases are caused by fears of a euro break-up. While this represents a sea-change in the ECB president’s thinking, it risks sowing dissension within his ranks. He will struggle to come up with the right tools to achieve his goals.

Draghi seemingly stared into the abyss and had a fright. Spanish 10-year bond yields shot up to 7.6 percent on July 24 while Italian ones rose to 6.6 percent. The high borrowing costs are not simply a reflection of the two countries’ high debts and struggling economies. Investors also fear “convertibility risk” – or the possibility that the euro will break up and they will get repaid in devalued pesetas and liras.

The central banker’s statement that dealing with convertibility risk is part of the ECB’s mandate is therefore highly significant. He rammed home his message, saying: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Markets responded swiftly. Spain’s borrowing costs fell to 6.8 percent, while Italy’s dropped just below six percent. But these yields have to drop below five percent – and stay there – before confidence in the euro project will return. What’s more, it’s unclear what Draghi will actually do.

One possibility, immediately latched onto by investors, is that the ECB will relaunch its programme of buying government bonds in the market. But such an operation would be tough to calibrate. If the ECB was prepared to do whatever it took to drive yields below a certain level, the pressure would certainly be off Spain and Italy. But politicians might then stop reforming their economies. When the ECB bought Italian bonds last summer, that’s precisely what happened.

That’s why Germany’s Bundesbank, which has a powerful voice within the ECB but no veto over its actions, is opposed to bond-buying – potentially setting the stage for a stormy meeting when the ECB governing council meets to discuss what to do on Aug. 2. It’s not yet clear how big a spoke the German central bank will be able to put into Draghi’s plans.

On the other hand, if the ECB made its support conditional on good behaviour, investors might not be reassured. Their anxiety would be heightened if central bank bond-buying pushed private creditors down the pecking order. That’s what happened when Greece’s debt was restructured earlier this year: private bondholders suffered big losses while the ECB theoretically stands to make a profit. A half-hearted bond-buying programme might therefore simply encourage investors to dump their holdings on the ECB while having no lasting effect on Spain’s and Italy’s borrowing costs.

Draghi may think that the two countries’ current leaders – Spain’s Mariano Rajoy and Italy’s Mario Monti – are more serious about reform than their predecessors Jose Luis Rodriguez Zapatero and Silvio Berlusconi. But even the new leaders have shown signs of losing momentum. Rajoy’s latest spurt of action – further budget-tightening and a plan to recapitalise the country’s struggling banks – only occurred because his back was to the wall. In Italy, meanwhile, Monti says he will stop being prime minister next spring. It’s not clear whether his successor will be committed to reform.

For these reasons, Draghi seems reluctant for the ECB just to buy bonds on its own. Rather, he seems to want to do so in combination with the euro zone’s bailout funds, which have the ability to buy bonds directly from governments – something the ECB is banned from doing. One advantage is that Madrid and Rome would have to sign memorandums of understanding setting out their reform plans in order to access the bailout funds. It would then be easier to hold them to their commitments.

A further idea, reported by Reuters, could help deal with private creditors being pushed down the pecking order. Policymakers are working on a “last chance” option to cut Athens’ debt – involving the ECB taking a haircut on its Greek bond holdings. If that happened, investors would worry less about being unfairly treated if Spain or Italy ever needed to restructure their debts. They might then not view bond-buying as the perfect chance to offload their holdings onto the public sector.

The two-pronged approach is preferable to the ECB buying bonds solo. But it would still put the central bank in the front line of rescuing governments. A better approach would be to scale up the euro zone’s bailout funds and get them to do the entire job of lending to Spain and Italy, if they need help. This could be achieved by letting the soon-to-be-created European Stability Mechanism (ESM) borrow money from the ECB.

Draghi should prefer lending to the ESM than buying Spanish or Italian bonds because, if either country got into trouble, the bailout fund not the ECB would take the first losses. Unfortunately, the ECB said last year that extending loans to the ESM would contravene the Maastricht Treaty – a position Draghi himself repeated after he took over as president, even though there are plenty of lawyers who think the opposite.

Super Mario is now warming to the idea of lending to the ESM, according to Bloomberg, even though that’s not part of his immediate plan. If Draghi does this, he’ll have to find a way to eat his words without losing credibility. If not, he will have to rely on second-best options with all their drawbacks. Mind you, it’s the job of super heroes to get out of tight spots.

 

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