ECB’s Draghi fails to back up his promises

After building up market expectations to near euphoric levels, ECB President Mario Draghi failed to deliver the policy to back up his promises of “doing whatever it takes to save the Euro”.

Given the timing of his comments last week, markets had rallied aggressively on expectations of further interest rate cuts and/or intervention in peripheral sovereign bond markets.

At today’s ECB press conference, Draghi confirmed the Governing Council’s decision to keep the main policy interest rate on hold at 0.75%, but announced that the ECB “may undertake outright open market operations of a size adequate to reach its objective (of price stability)”.

Though at first glance Draghi appears to be announcing the start of quantitative easing, closer inspection of his opening statement and follow-up comments show that the ECB is merely considering the idea of creating a framework that could allow such action. Not a great deal of conviction in the statement. Moreover, Draghi would not comment on the potential size of potential bond purchases, nor the timing, suggesting that the Council may still be some way from agreeing how best to proceed, if at all.

Oddly, Draghi did state that any ECB purchases would be done using short dated government bonds, hinting that the ECB would avoid buying longer dated debt. This suggests a sort of reverse operation twist, whereby the ECB’s purchases would only help governments raise finances in the short-term, ensuring that they are kept on a tight leash with higher long-term interest rates. Indeed, Draghi stressed the need to deal with the moral hazard problem of supporting governments in such a way. He stated that any intervention would only be done in the secondary market, and only after governments are meeting the conditionality set by European leaders and the IMF.

So it appears that there is no chance of the ECB intervening in primary markets, and any intervention in secondary markets will only come after Spain and Italy request help. Of course, for Spain and Italy to successfully negotiate help with the Troika, they must show that they cannot raise financing through financial markets – in the same way Greece, Ireland and Portugal were forced to demonstrate. They must also agree to conditionality that is likely to be more severe than the austerity plans they are currently implementing, and that are pushing them deeper into recession.

The lack of detail and certainty over how the ECB intends to help is very frustrating. There are big questions around the scope and legality of its proposed policy tools. Will bond purchases be sterilised? How do they intend on dealing with the seniority issue with regards to existing bond holders. It is therefore no surprise to see stock markets in Southern Europe fall sharply in response to Draghi’s disappointing announcement. What is worse, it is clear that some members of the council oppose bond purchases (no prizes for guessing which). If the ECB does not follow up with some meaningful action in the near future, then there is a risk that markets lose all faith in Draghi and the governing council’s ability to tackle this crisis. Draghi warned investors not to bet against the Euro, but the trouble is those that are doing so have done rather well so far this year.

Azad Zangana is European Economist at Schroders

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