EU Summit: The quest for a united Europe?

More Neil Staines, yesterday09 December 2011

“Unity can only be manifested in the binary. Unity itself and the idea of unity are already two” - Buddha 

Mario Draghi was both hero and villain yesterday when he delivered his second ECB press conference yesterday. The governing council voted to cut the benchmark interest rate by 25bps to a record low 1.00 percent, in a decision which was not unanimous (although we were assured that the dissent was in relation to timing and not substance). The cut was perhaps not as aggressive as I for one would have liked to have seen but the measures which were subsequently announced in the press conference went further than market expectations. 

The ‘hero’ (Super Mario) delivered a range of non-standard measures (“of course temporary in nature”) aimed at further relieving the funding stress in the banking system. Ultimately, Draghi sanctioned unlimited loans to banks in the form of three-year LTRO’s with a break option after one year. In addition to this the ECB lowered the collateral criteria for those loans and reduced the reserve ratio from 2 percent to 1 percent. The announced measures are directly aimed at enhancing the funding and asset quality issues that have become increasingly acute within the Eurozone recently with the direct aim of aiding banks and the flow of credit to households. 

In a more simplistic world, these measures should have been positive for risk assets (particularly bank stocks), however, the world of the Eurozone crisis is far from simple. Enter Wario, Super Mario’s villainous alter ego. Within the press conference Mario Draghi was asked to clarify a statement that he had made previously in relation to further measures from the ‘fiscal compact’, which the market had taken to mean that the ECB would at some point step up its purchases of Eurozone Government Bonds. His response was that he “did not signal more bond purchases last week” and that he was surprised by the interpretation of his comments!

Market focus
From the conception of the Franco German accord on treaty change and the subsequent letter to the EU President (covered in yesterday’s blog), the perception has been that greater fiscal integration and regulation in the EU (17 at least) would give the ECB the legitimacy to step up its bond purchases.  Therefore Draghi’s rejection of the markets prior assumptions and the further statements that “Article 123 of the Treaty says no monetary financing to governments” and that the SMP, the vehicle through which the ECB purchases Government Bonds in the market under the broad justification of maintaining the transmission mechanism for monetary policy, is “not eternal or infinite”. 

For the eternal optimists that the ECB will eventually come to the rescue as lender of last resort to governments, effectively embarking on a more traditional and transparent form of Quantitative Easing, there were a couple of subtle points that are worth noting. On several occasions Draghi referred to the “spirit of the treaty” and also that the ECB was now ready to act as agent for the EFSF in buying bonds.  Whilst the ECB balance sheet will not be involved in such transactions (and hence it is not any form of monetization), both comments provide a platform for flexibility and interpretation if the situation deteriorates further. 

The fact that the market paid greater attention to the fact that the ECB seemingly held firm to its line that it will not enter into monetary financing of governments but will continue temporary bond purchases under the SMP (although the larger the holdings under the rationale of maintaining the monetary transmission mechanism get the more blurred this distinction becomes) highlights both the severity of the situation and the importance of today’s outcome. 

A way forward
In my mind the issues remain too complex and too disparately viewed for the Treaty to reach a decisive conclusion today. Sentiment from Angela Merkel in this regard that “ending the crisis requires years of hard work” and that she is open to another EU summit this month should the meeting fail to reach an adequate solution, suggests confidence that a solution is waning. In reality there are also a number of member states that would require a referendum in order to ratify treaty change, adding a further level of uncertainty. 

Today is therefore likely to be very quiet as the markets patiently await the press conference scheduled for around 3pm this afternoon. Today is also likely to mark an important point in the relationship between the UK and the broader EU. Post 3pm however we could reach a new high point in volatility, in what in terms of the broad risk backdrop is becoming an increasingly binary event. 

“The empires of the future are the empires of the mind” – Winston Churchill

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