27/7/2012: Some thoughts on Draghi's thoughts

Just two reactions - reflective of the markets sentiment - to yesterday's statements by Mario Draghi:

Markets are thin, as Europe slides into its annual 'Beach lounge & sun screen' mode, but nonetheless yesterday's statement by the ECB chief is significant. Not a game changer overall, yet, but a sign that the team captain is starting to see the problem more clearly.

So what did he really say?

1. Raised a possibility of direct bonds purchases for distressed sovereigns (read: Italy and Spain) - in my opinion a minor issue. Take Spain - from now through mid-2015 it will need €542 billion to roll over existent bonds and fund itself, plus €20 billion potentially in regional financing. ECB's hands are currently relatively tied when it comes to rescuing Spain by the fact that two out of three tools ECB can use to do so are ineffective if not damaging to Spain. Usual policy tool of lowering interest rates will have little-to-no impact on Spain which is suffering from the same breakdown in the monetary policy transmission mechanism as the rest of the euro zone. Draghi hinted at as much within the overall euro area context. ECB can use the LTRO3 tool. Alas, (1) this would mean that LTRO3 will be explicitly focused on financing sovereign (as opposed to banking sector) needs; (2) financing Spanish Government via LTRO3 would only increase contagion from the sovereign to the banks and back to the sovereigns; (3) Unable to issue LTRO to a specific country, the ECB is likely to risk even more carry trade and contagion across the euro zone as the result of such a move. So the only tool left is SMP. ECB has built up some back pressure here with no SMP purchases in 19 weeks, hence the trigger reaction yesterday to Draghi's statement, but I have severe doubts this will work, even if restarted as the scope for SMP purchases for Spain would be well under €75-80 billion - a drop in the funding requirement.
2. Noted that elevated sovereign yields can restrict the monetary policy transmission mechanism (presumably via the heightened liquidity trap effects and carry-trade incentives), which would bring them within the ECB mandate. This is consistent with his statement to the EU Parliament earlier this month where he stressed that both inflation and deflation are part of the ECB mandate. More specifically, Draghi said that "The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area... Investors retreated within their national boundaries. The interbank market is not functioning... the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation... So [first] regulation has to be recalibrated completely." In other words, Draghi sees regulatory, not balancesheet barriers to interbank lending (and thus regulatory causes of a liquidity trap). Fine, but that does not mean a short-term response on the cards. And it does not mean a major departure from the previous position of the ECB that regulatory fix must be applied ahead of monetary fix.
3. Spoke about the fact that the ECB mandate is too restrictive to deliver effective monetary policy - again re-iteration on his statement to the EU Parliament and potentially a clear signal the ECB would not mind if its mandate was expanded. Yesterday, Draghi went further to link the ECB unbalanced mandate to the ECB's ability / willingness to act in the sovereign bond markets. This is what referenced in the quote that the ECB is 'ready to do whatever it takes' to preserve the euro. But the quote contains much more than that: "...another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia [relate to] default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty – they come into our mandate. They come within our remit." FTAlphaville has a good note on the convirtibility bit (here).

In short, I don't read Draghi's statement as a major and definitive turnaround in the ECB policy, but rather a continued sign of ECB drift toward pressuring both: 

• the markets sentiment, and 
• the euro area policymakers to act to increase ECB powers and/or carry out significant policy framework changes (ESM, banking union etc).

Continued is the key word here, because, in my view, yesterday's statement is not as divorced from the earlier Draghi comments as some analysts might suggest (or wish for).

These pressures, however, is an important component of policy drift across the euro zone. Leaderless Europe needs a jolt from the ECB to force it out of policy stalemate. That such an approach might be working is reflected in this latest report from the 'front'.