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Tuesday, March 12, 2013

When Is A Promise Not A Promise?

Mario Draghi is proving to be a man of his word. He said he would do whatever he needed to do to hold the Euro together, and - so far so good - he has. Up to now of course some would say his will has not been truly tested, since all he has had to is sit there and twiddle his thumbs, and that has worked. It seems to have been the subliminal symbol the markets were waiting for.

But now he has added to his repertoire, and gone one stage further. This time he really did do something. Last Thursday he openly and publicly turned a blind eye to a blatant example of  monetary financing being carried through out there adjacent to  the flagship's starboard bow. Like Nelson peering along the length of his telescope at Trafalgar, he saw no monetary financing activity in Ireland. The reason he didn't see it was because he simply didn't look. Naturally he did tell curious journalists last Thursday that someone one day would do so, but such was his control of the situation  he even feigned  he couldn't remember the date when they would take that look. Nice one Mario.

Thus he kept to his promise, while allowing the Irish government to sharply revise down the net present value of one of  theirs. 

The really impressive part in the performance was the extraordinarily skillful way in which the ECB's very own Lord High Admiral managed to navigate his flagship through the tiny skiffs of the assembled press corps. At one point he almost taunted them with their own impotence, appealing to some seemingly innate masochistic tendency they share  by giving them a dressing down for the way in which they constantly get things out of proportion while jocularly  drawing their attention to how they were prone to a sort of  “angst of the week” syndrome. It always helps when you want to insult someones intelligence if you start off by saying, "let me tell you a joke."

What he had in mind were things like, well you know, the size of the ECB balance sheet (what a thing to fret about), the value of the Euro, the threat of currency break up, deposit flight from the periphery, the hawkish Bundesbank etc etc. The list of causes for such childlike angst could be very, very long. When all is for the best in the best of all possible worlds, what on earth could reasonable men and women be doing worrying their silly little heads about so many and such varied topics? These things are better left in the capable hands of the big boys over on the ECB governing council who, self evidently, know exactly what they are doing. Another nice one Mario.

Curiously though one "angst of the week" the journalist didn't seem to be suffering from at last Thursday's press conference was whether or not "monetary financing by stealth" might be going on in Ireland. After all, why should they have been, it's such a trivial item.

However, surely even those with the shortest of short memories must somehow or another be able to  recall  that notorious Irish Promissory Notes issue. This certainly was fret of the week in February, but had somehow - apart from one isolated question - conveniently slipped off the radar by the time we got to March. But just as a reminder, here's the story so far.
February Press Conference

Question: Unfortunately, I have one more question about Ireland. You said that it is a decision of the Irish government and probably the Central Bank of Ireland, and not your problem. But, at some point, I guess it could still be a Eurosystem problem because, as I understand it, the Central Bank of Ireland is now the owner of a promissory note, or something else, maybe government bonds with longer durations, which should be part of the so-called ANFA assets. I know that there are certain rules which cap these assets so, at some point this year, you have to look at that. Do you have any proposals for the Central Bank of Ireland to reduce that?

Draghi: You are running too fast, you are running ahead. We will certainly review the situation in due course. I am not saying that this is the last word on this. I am only saying that, today, the Governing Council unanimously took note of the Irish operation. So I have to say that this is certainly not the last word. We will come back to this.
Fine, we don't want to precipitate things. We need to consult so for the moment we are only taking note with no further comment. But what a difference a day makes, come March  they were not even taking notes. Poor Mario couldn't even remember the date when the Governing Council was planning to come back to the matter. Curious..................
March Press Conference

Question: Last month you said that we have not heard the last word on the Irish promissory notes. So, I wonder, when will we hear the last word?

Draghi: We periodically review compliance with Article 123 by all countries. If I am not mistaken, the review should happen at the end of the year, but the Governing Council will decide in complete independence when to have this review, or a review of similar situations. I do not have a date to give you now. I think there is a date when this is going to be done, and I believe it is at the end of the year, but I cannot let you know for sure .
Now for those who need reminding  Article 123 of the EU Treaty is the one which explicitly prohibits monetary financing by either the ECB or national central banks. The agreement reached between the Irish central bank and the Irish government would certainly appear to breach the letter of that article, and given the way the Bundesbank has voiced such concerns over the months about anything that even vaguely smack of it, you'd have thought it would have been a hot topic.

Under the agreement, the Irish Central Bank agreed to assume full ownership of the 25 billion Euros in in promissory notes issued by the Irish government when it bailed out Anglo Irish bank. Subsequently these notes were exchanged for Irish sovereign bonds with maturities of up to 40 years. The first principal payment is not due till 2038 and the last payment will be made in 2053.

In addition the average interest rate was massively reduced. Interest on the new bonds will begin at just over 3%, compared with well over 8% on the promissory notes. Evidently the Irish government has just been relieved of a short term burden on its finances to the tune of over 2 billion Euros a year. This money can now be put to use stimulating the Irish economy, avoiding damaging cuts as the fiscal deficit is steadily reduced. If this isn’t monetary financing, then it isn’t exactly clear what would be.

Growing Weariness At Both Ends Of The Curve

 So what happened between the two press conferences? The Italian elections happened, that's what happened. What the Italian election outcome suggests is not just that Italy won't find it easy forming a government, that part is obvious. More importantly there is a growing recognition that even after a government is formed, twisting its arm to push through a hefty reform programme is going to be difficult, and in the meantime Italy's debt to GDP ratio is simply going to keep going onwards and upwards (it was near 130% by the end of 2012, and rising), no matter how much soothsaying goes on about how the country now has a primary balance.

So at some point this surge in the debt level will need to be capped, and I think there is a growing resignation about this fact in Brussels, Berlin and Washington. It is this resignation that the markets are sniffing, when they aren't taking the appropriate advisers out to lunch to get them to spill the beans, and this is why the periphery bond spreads are reacting so calmly to almost anything.

Italian debt will need to be restructured, or at least "re-profiled" (that basically means extending the term of the debt  say to 30 or 50 year bonds in a way the the Net Present Value is significantly reduced), just like that of its Greek peer. But hey, isn't that just what the Irish government got the Irish central bank to sign up to and, as John Dizard points out, didn't Maria Cannata, director-general of public debt in Italy, recently go so suggest that the country might soon be issuing bonds in the 30 to 50-year range? "We intend to restart with the lengthening of the duration in the average life of our debt," she told an investor conference in London recently. "We are ready to launch also a new 30-year (bond) as soon as possible."

So while Europe's central-bank-watching journalists may momentarily have lost sight of the problem, hedge fund research teams surely  haven't, indeed I think it would be pretty difficult to understand why markets are responding so calmly to the absence of even the first signs of a stable government in Italy. Somehow or another one gets the feeling that none of this now matters, risk premia will come down regardless.

Something similar seems to be happening in the case of Spain. At the end of last week Spanish 5 and 10 year bonds reached their lowest yield level since November 2010. And this in a week when credit rating agency Moody's announced they had identified 200 billion euros worth of badly classified property assets in Spain's bank balance sheets, assets which had not been specially provisioned for. Isn't financial sector risk supposed to be one of the main risks to Spanish debt and solvency? How come the stock market continues to go up even as almost every real economy indicator deteriorates. A combination of reform weariness on the periphery and bailout weariness in the core is producing what many perceive as being the perfect storm. A world where almost nothing can go wrong, unless that is you are in Spain or Greece and searching for a job. In fact it is now starting to look increasingly unlikely that Mariano Rajoy will ever ask for those famous Outright Monetary Transactions bond purchases ever to be implemented. Landon Thomas - like many of us - had it wrong, the world wasn't waiting for Mariano, it was waiting for Mario to see if he would just keep twiddling his thumbs.

Will The National Central Banks Support The Bond Markets No Matter What?

Naturally this is a win win solution - for the ECB, the Bundesbank and for Angela Merkel who won't have to keep going to the German parliament to get authorisation for yet more bailout money. So maybe this is an important moment in the crisis. The moment when you can say that one stage is over, and another, the one Citi Chief Economist Willem Buiter once called the Rubelisation of the Euro Area , about to begin. Now it could be that national central banks rather than  the ECB will become the focus of attention, at least in terms of assuming the risk of growing debts in countries that are going to have trouble ever paying it all back.

As I said in this post back in October last year:
The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray [Dalio] argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren’t necessarily doing when they increase their balance sheet) ain’t seen nothing yet. That’s what the “it will be enough” promise means. None of this is in the mandate yet, naturally it isn’t, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you’re crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back.

FT Alphaville's Izabella Kaminska also senses it, "Something very important has changed, which makes this a very different type of bubble.The government will continue to support the market no matter what....The crisis happened precisely because there weren’t preset expectations of government support."

Izabella is of course talking about the United States government, but the point is generalizable. The Euro crisis broke out precisely because there weren't expectations of collective support for the struggling countries. As I pointed out at the time, the Greek crisis broke out in the wake of what happened in Dubai, where markets started to doubt that big brother Abu Dhabi would bail the country out. The same thing happened to Greece, expectations of German government support dwindled largely because the government itself was denying it would. But now, four years later a formula has been found: march together but strike separately, or something like that.

So it is to Mario Draghi's credit that he has shifted that perception, he vowed he would save the Euro no matter what, and now inadvertently the Irish government have offered investors a blue print of how it might all work. The national central banks will support their sovereign bond markets, no matter what. After all, isn't that just what the new Japanese Prime Minister Shinzo Abe has said he is going to do, and aren't the global financial markets whirring resplendently with joy just hearing him saying it.

Why in the end should Europe be so different? Maybe it will all end in tears, but it will be fun while it lasts.

So we are off on a splendid monetary experiment, with Japan leading the pack. As Paul Krugman so aptly puts it it in the title of a recent article -  "Is Japan The Country of the Future Again." And the moral - "It will be a bitter irony if a pretty bad guy, with all the wrong motives, ends up doing the right thing economically, while all the good guys fail because they’re too determined to be, well, good guys."

He wasn't by any chance talking about Silvio Berlusconi, was he?

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

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