July 27, 2012

Draghi’s Dilemma: ‘Whatever it takes’ Could Alienate Fellow ECB Members

Markets rejoiced at his words, but some of his colleagues disagree

Mario Draghi, president of the European Central Bank (ECB), may have painted himself into a corner with his London speech on Thursday promising to do “whatever it takes” to rescue the euro. Markets rejoiced at his words, sending yields on Spanish and Italian bonds lower—at least temporarily—but it remains to be seen exactly what Draghi will—or can—do.

Bloomberg reported Friday that a number of policymakers on the council of the ECB remain firmly opposed to one possibility, that of the ECB resuming its bond purchase program, or Securities Markets Program (SMP), which it halted in March. And that could leave Draghi in a tight spot.

“Draghi is damned if he does and damned if he doesn’t,” Carsten Brzeski said in the report. Brzeski, senior economist at ING Group in Brussels, added, “He maneuvered himself into an extremely difficult situation. Expectations are very high.”

Heavy opposition continues from such council members as Bundesbank President Jens Weidmann, as well as from former Bundesbank President Axel Weber, who declined the top post at the ECB over the issue, and ECB Chief Economist Juergen Stark, who retired at the end of 2011. The strength of the opposition makes some economists feel that the ECB will not revisit the policy any time soon.

“I don’t believe you will see government bond purchases yet,” said Jacques Cailloux in the report. Cailloux, chief European economist at Nomura International in London, continued, “But there are other things they can do that will help, such as lowering the haircut on sovereign bonds they accept as collateral or buying private-sector securities.”

Markets will not be happy if there is no decisive action taken soon. While at first bond buying was effective, it soon developed that it did not go far enough in magnitude or degree to keep yields down. That led to the ECB’s offer of three-year unlimited loans at exceptionally low interest rates. That, too, failed to reassure markets and contain the crisis, and many are critical of the central bank’s efforts.

Richard Urwin, head of investments at BlackRock’s Fiduciary Mandate Investment Team in London, was quoted saying, “We still don’t think policy makers have done enough to make the market sit up and take note.”

While there are other options to bond purchases, such as giving the ESM a banking license, Draghi did not mention it in his speech on Thursday, and has been opposed to such a move when previously suggested.

It may be that a return to bond buying, and in a big way, is the only way to ward off further escalation, and some economists are voicing their thoughts on the matter. Marius Daheim said in the report, “The ECB appears to be running out of conventional ammunition.” According to Daheim, a senior fixed-income strategist at Bayerische Landesbank in Munich, “What is left … is the ‘bazooka’”—large-scale intervention in bond markets.

Julian Callow, chief international economist at Barclays Capital in London, was quoted saying, “The thing we wonder here is exactly where the Bundesbank stands.” He continued, “The Bundesbank has historically been resisting the reactivation of the SMP. In the view of most economists, the ECB is justified in reactivating the SMP.”

Nick Kounis, who heads macro research at ABN Amro in Amsterdam, was not so sure that it would be enough. In the report, he was quoted saying that “the crisis response looks likely to focus on direct intervention in the government bond market. We have some doubts about whether the interventions will be of the required scale. It therefore seems likely that the bond purchases will just allow policy makers to muddle through unless much more financial firepower is put on the table.”

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