Washington Insight: EU Update
Provided by my partner, ACG Analytics
Key Summary
The net positives from the ECB governing council meeting yesterday can be
defined as follows:
Likely further Greek sovereign debt reduction, reducing systemic risk of Greece euro exit. Introduction of ECB bond purchasing program to reduce yields on short end of the curve which should reduce Spanish cost of borrowing. Likely introduction of further long term liquidity into Eurozone banking system reducing systemic risk of bank debt default and potentially increasing flow of credit into real economy.
The net negative from the ECB governing council meeting can be defined as follows:
Uncertainty arising from ECB conditionality for bond purchasing program, which Italy must also apply for EFSF/ESM funding thus posing risks to cost of Italian borrowing in the short term.
Given the size of the Italian economy, coupled with funding required for Spain, it is difficult to see how an Italian EFSF/ESM official sector financial assistance application could be anything other than a considerably negative market moving event. Therefore in the event of such an application, there are really only two ways in which the contagion risk could be diminished.
Very expansive and aggressive ECB bond purchasing program of Italian bonds on short end of the yield curve. An ESM change to lending directly to financial institutions reduces considerably the cost of borrowing for Spanish yields, presenting positive contagion impact for Italy’s cost of borrowing.
If neither of the above occurs, the only other firewall available to policy makers to contain contagion spillover and systemic risk from Italy, would be the legal facilitation of affording the ESM eligible counterparty status
with the ECB for the purposes of increasing the EFSF/ESM lending capacity.
A Spain application for EFSF/ESM sovereign assistance is now as close to an absolute certainty as it has ever been. A very dull game of cat and mouse between the ECB, Spain and its Eurozone partners is likely to play out for
a few more weeks, with several defiant statements from Spain that it needs no official sector sovereign assistance. This charade is likely to be a side show to the main event, which is whether an Italian official sector financial assistance application for the EFSF/ESM is equally forthcoming.
Key Analysis
It remains in our view unlikely that Spain would seek sovereign EFSF/ESM financial assistance until the full capital cost for its banking system is known in mid-September. It is also equally unlikely that a joint
Spanish/Italian EFSF/ESM application for bond purchasing or credit line would be forthcoming either, and much more likely that Italy will postpone for as long as economically viable an EFSF/ESM application.
While Draghi continues to point to a legal opinion published in March of 2011 that effectively states ESM could not be an eligible counterparty for ECB funding, even with a banking license, in our view the likelihood of
Germany being forced into conceding to allow the legal facilitation of an ESM banking license to access ECB funding has increased as a result of the conditionality being imposed on the ECB bond purchasing program.
Given the size of the Italian economy, coupled with funding required for Spain, it is difficult to see how an Italian EFSF/ESM official sector financial assistance application could be anything other than a considerably negative market moving event. Therefore in the event of such an application, there are really only two ways in which the contagion risk could be diminished.
Very expansive and aggressive ECB bond purchasing program of Italian bonds on short end of the yield curve. An ESM change to lending directly to financial institutions reduces considerably the cost of borrowing for Spanish yields, presenting positive contagion impact for Italy’s cost of borrowing.
If neither of the above occurs, the only other firewall available to policy makers to contain spill over and systemic risk from Italy, would be the legal facilitation of affording the ESM eligible counterparty status with
the ECB for the purposes of increasing its lending capacity.
The ECB governing council meetings on the 20th of September 2012 and 4th of October 2012 are likely to pave the way for market intervention in short term Spanish yield curve and also clarity on the other non-standard
monetary measures. The aftermath of those meetings and ECB action is likely to determine Italy’s fate and how long it can attempt to stave off an EFSF/ESM application. The sooner an application looks in the offing, the
more likely it is that Germany would be forced to realistically consider allowing the ESM access to ECB financing.
A. ECB
In our report on the 31st of July 2012, it was our assessment that the announcements arising from the ECB governing council meeting held on the 2nd of August 2012 would achieve the following results:
Reduce cost of Spanish borrowing over short to medium term period Act as incentive for Spanish state to seek some form of financial assistance from EFSF/ESM to reduce need of Spanish sovereign to access capital markets over medium term period of 3 to 6 months. Provide firewall to reduce Italian yields over short to medium term period as a result of contagion spillover from Spain sovereign official sector assistance. In our view, increase the likelihood of losses being imposed on senior creditors in BFA/Bankia, Catalunya Caixa, NCG Banco and Banco de Valenci.
Despite the negative media headlines on yesterday’s ECB governing council meeting and Draghi’s subsequent statements, most of the media negativity reflects wildly unrealistic expectations for the meeting itself, rather
than objective assessments of plausible outcomes.
While the elements cited above are no panacea to the Eurozone crisis, there
are net positives to be found and all 4 elements cited above have occurred
as a result of yesterday’s governing council meeting.
A fifth element, which we had not expected as soon as the August ECB
governing council meeting, and is significant, is the ECB’s commitment to
address seniority concerns with respect to the bond purchasing program.
A. Spain cost of borrowing
While 10 year cost of borrowing for Spain rose, the short end of the curve,
namely 2 year bonds have reduced from 4.94% to 4.07% as the ECB indicated
its intention to engage in a new bond purchasing program different from the
SMP, at the short end of the curve of those Sovereigns “when exceptional
financial market circumstances and risks to financial stability exist.” [1]
B. Act as incentive for Spanish state to seek EFSF/ESM financial assistance
Draghi was unequivocally clear that ECB market intervention would only come
once an official sector application had been made to the EFSF/ESM by a
respective state.
“the adherence of governments to their commitments and the fulfillment by
the EFSF/ESM of their role are necessary conditions. The Governing Council,
within its mandate to maintain price stability over the medium term and in
observance of its independence in determining monetary policy, may
undertake outright open market operations of a size adequate to reach its
objective”[2]
As we have stated for some time, it is only a question of when and not if,
Spain seeks some form of official sector assistance from the EFSF/ESM to
allow it meet its sovereign funding requirements over the medium term. Such
assistance would be intended to be put in place until such time that the
changes to the EFSF/ESM lending directly to financial institutions can be
established, considerably reducing its overall sovereign debt which
ultimately should be reflected in its cost of borrowing.
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