Friday, November 18, 2011

Pressure is building on the ECB

Following up on our earlier post, pressure continues to mount on the ECB to act either in direct capacity (as a buyer of bonds) or as the funder of the "bazooka" funding vehicle. This pressure is coming not just from the eurozone states but also from nations such as the UK who has been hurt by the crisis in spite of not being a member of the common currency union. The ECB's new president Mario Draghi is pushing back.
From the FT:
Mr Draghi said ECB credibility in controlling inflation was “the major contribution we can make”. But “losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs”.
Italy and Spain are coming to a realization that it's only a matter of time before they may no longer be able to successfully roll their debt as bond auctions are becoming increasingly difficult and the traditional buyers are no longer willing to step up.
“There is only one solution, and that is that the ECB, once and for all, does what it is supposed to do,” said Alfredo Pérez Rubalcaba, the Socialist candidate in Spain’s election, who is expected to lose to Mariano Rajoy, the Popular party opposition leader.
The ECB in fact has been buying Italian bonds today, stabilizing the yields of not just Italian but also French bonds. Ideally one of their mandates could be to cap the spread between the highest and the lowest yielding bonds of the member states. To avoid "printing money" they could for example purchase Italian bonds while shorting German bonds via a repo/reverse repo arrangement. But the ECB is limited in the amounts they can currently purchase.
ECB guidelines have capped the amounts its dealers can spend on eurozone government bonds over a two-week period at about €20bn, although it has often spent less than that.
The danger of these escalating yields is the chain reaction that moves from government bonds to banks to corporations, bringing these economies to a standstill. For example Deutcsche Bank (DB) may cut its overall Italy exposure (as it probably already has). That means fewer Italian government bonds held and no new debt purchased. But that country exposure reduction would also include corporate debt. If there is nervousness about Italian government credit risk, why would DB want to buy Italian corporate bonds or lend to Italian corporations. Government debt ends up "crowding out" corporate debt. When time comes to refinance debt, Italian firms will have no place to turn. Cutbacks, defaults, layoffs, and a recession will ensue. That in turn will reduce tax revenues drastically, making it more difficult for the government to pay on its debt, raising yields higher and forcing banks like DB to reduce their holdings further. It's a death spiral.

Pressure is building.
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