Can the ECB make the PIIGS’ mission impossible possible?

Germany and France are in a political saber-rattling with regard to the question whether the ECB should shift to a policy of large scale purchases of the PIIGS’ sovereign bonds via the creation of money. This would push down yields on for example Italian and Spanish government bonds, making it easier for these countries to tackle their economic difficulties. Without ECB support to lower yields, lowering debts and stimulating growth would be mission impossible. Such a policy would imply an expansion of the money supply, weakening the euro and probably leading to initially rising stock markets and long term bond yields for the stronger EMU countries.

France is a fervent advocate of such ECB policy, since a further drop in the prices of PIIGS’ sovereign bonds would drastically deteriorate the position of its banks. Were the ECB not to intervene, it is likely that many French banks would have to be nationalized. As a result the fiscal health of France would weaken and the country would loose its cherished AAA-status– as some credit rating agencies have already indicated –, making it the next victim in the euro crisis. More importantly still, the EFSF – the European emergency fund that should keep the weaker countries floating – would then see its fire power decline even further. This is something that Germany will want to prevent, but Germany nevertheless has two objections to ECB money printing:

 

• Such an inflationary policy would be in violation of the mandate of the ECB. Germany’s fear is that, as soon as it is allowed, it would be the end of price stability, while money printing will not address the (sovereign) debt issues and could even amplify them.
• All European economies – including Germany – would benefit from keeping the monetary union together as much as possible. This, however, can only be achieved if economic policy in countries such as Italy and Spain is altered significantly. Luckily these countries’ new leaders are willing to implement the necessary reforms. These are, however, hugely unpopular with the voters. Pressure from abroad is thus necessary to force implementation of difficult reform packages. And the ECB can exert this pressure by not intervening as much that interest rates drop.

 

The pragmatic German chancellor Merkel seems to be pursuing a strategy whereby new rules are being instituted to which EMU countries have to comply. These should guarantee a policy that focuses on stimulating growth and keeping debt controllable. One should expect proposals in this respect within one month or so, but the question remains whether all countries can indeed comply. Most likely, not all countries will be able to. This implies that financial markets will keep into account the possibility of one or more countries exiting the Eurozone. A result then is the large scale selling of especially peripheral government bonds, pushing interest rates North. Consequently, countries such as Italy and Spain would be facing mission impossible when it comes to controlling the debt burden and pursuing (on the short term costly) reforms that stimulate (long term) growth. Since this is not in the interest of Germany, it will allow the ECB to temporarily buy as many government bonds as necessary just to prevent the debt crisis from exploding.

This does mean that the euro will be under increasing downward pressure due to the ECB money printing policy and ongoing uncertainty with regard to Italy and Spain, which is stock market-negative and might mean that a bottom in long term bond yields for the stronger countries – most notably Germany – is near (given that investors are fleeing Europe and inflation fears are becoming more pronounced). In such a climate, EUR/USD could ascent to maximally 1,38 à 1,40, but in our view an immediate drop towards 1,315 and thereafter even towards 1,20 is more likely.