Saturday, September 8, 2012

Where next for the euro area?

7 September 2012
Following yesterday’s announcement of the details of its new Outright Monetary Transactions (OMT) programme, markets today continued to react favourably, with peripheral spreads narrowing further. But, as we argued yesterday, the ECB’s announcement represented only the first step on the road to eventual purchases. It is now up to the countries themselves and the EU/IMF to take the next step. The risk now is that the countries try to hold out, hoping (probably beyond hope) that the mere threat of ECB purchases will be sufficient to cap yields without having to sign up to new reform programmes.

Certainly the Spanish government, the one under the most pressure, appears in no hurry to apply for a bailout package. And its reluctance is understandable – having managed to agree to a banking bailout with only very light conditionality, the ECB is now telling the Spanish government that, if it wants its help, it will effectively have to submit itself to the full rigours of the Troika. Given the political consequences such a move would probably have for the Spanish government, it is likely to want to do everything possible to avoid applying for a full programme. Ultimately, however, given the magnitude of the country’s economic and financial challenges, markets are likely to want see the government take up the ECB’s offer.

For Italy, the problems in negotiating some sort of programme in the near term are even more problematic. Monti’s caretaker administration is entering its final days, with elections due in April. There would be no guarantee, therefore, that any agreement struck with the Monti government would be adhered to by its successor administration. This was similar to the problem faced by the euro area authorities when negotiating the Portuguese bailout in the run up to elections there. In that instance, all of the main political parties were required to sign up to the bailout conditions, meaning that they went into the election backing the bailout. But the market pressure on Portugal was much greater than that faced by Italy, particularly now that the market has recovered on the back of the ECB’s announcement of its OMT. Getting the main Italian parties now to agree to the conditionality that would be required to activate ECB purchases ahead of an election may well be impossible in the absence of severe market strains.

So, while markets are currently happy that the ECB’s bond purchase scheme stands ready to be activated, getting the Spanish and Italian governments to agree to programmes is likely to be fraught with difficulties. Indeed, the positive market reaction makes their activation less likely by taking the pressure off the Spanish and Italian governments. So, it may well require a significant deterioration in market sentiment once again to ultimately trigger the programmes that lead to ECB purchases.

There’s certainly no shortage of events over coming weeks that could unsettle markets once again. First up is the coming week’s German Constitutional Court decision on the ESM. While there is a risk of a further postponement in the Court’s judgement, most observers expect the Court to allow the ESM to go ahead. However, the key will be the degree to which the Court emasculates the ESM by requiring additional conditionality on its operations. And, of course, the issue of Greece looms ever larger. The Troika continues to work on securing agreement to the reforms required to get the second bailout back on track. But with patience with Greece running out fast in the euro area, and a more effective backstop potentially in place in the form of the OMT, euro area leaders are unlikely to be overly indulgent of Greece when the time comes to decide on whether to continue disbursing financial support. If the Greek government can’t deliver its side of the bargain, then a Greek exit would be assured, an event that has the potential to trigger severe market tensions in the rest of the euro area, particularly if Spain and Italy have still not agreed EFSF/ESM programmes by then.

Grant Lewis
Head of Research
Daiwa Capital Markets Europe Limited

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