Immediate euro crisis over, ball back in PIIGS' court
After many nerve-wracking months, the European authorities finally seemed to have got it together, though not without tense moments. While European Central Bank President Mario Draghi managed to finally get his way to intervene in bond markets to save the euro, he admitted on Thursday that one country voted against his proposal to buy unlimited number of bonds—when asked which that country was, he said he would leave it for reporters to guess. Though markets had factored in the likelihood of this, the announcement of no “ex ante quantitative limits (being) set on the size of (the) outright monetary transactions” and that the ECB “will have a fully effective backstop to prevent potentially destructive scenarios”, got markets excited. With this, the ECB will operate in the short end of the market (below three years) to lower costs for periphery or PIIGS countries—a vital move considering these countries were being shut out of the bond market.
But it is important to keep the caveats in mind since, over the past year, the euphoria over the solutions arrived at each crisis summit has taken only a few days to dissipate. First, Draghi made it clear the bond purchases would take place only for countries that agreed to tough structural reforms and would stop the moment such reforms stopped—indeed, Draghi spoke of involving the IMF in administering the process, though how was not stated. This itself puts a huge question mark over the programme since every country undertaking such reforms, like Greece, is looking for relaxing the conditionalities. While Draghi clearly wrested the day and said there were no ex ante restrictions on his bond-buying budget, it is foolhardy to think Germany will give ECB a blank cheque regardless of the success. Second, Draghi made it clear the success of his programme depended on European governments backing up with funds for the EFSF/ESM, and that is clearly conditional on Germany’s support. Even if, for the sake of argument, the ECB was able to lower interest rates to, say, 5% in Spain, that still means a real interest rate of 2.5-3%, too high to get anyone to invest in an economy that is contracting. In other words, Draghi’s bond purchase was a necessary step—to keep the euro from collapsing as investors realise there is a backstop—it is by no means sufficient.
Draghi gave out figures on how long the haul could be—growth of -0.6% to -0.2% this year and between -0.4% and 1.4% in 2013—but the immediate trigger to watch for is whether or not Italy and Spain agree to ask for help and go in for strict conditionality-based reforms. Though Spain is negotiating for a 100 billion euro loan for its banks, it is unwilling to accept a bailout package since it is not certain an economy with 25% unemployment can take any more sacrifices. Both countries are too big to bail out and Draghi has made it clear he can help them only up to a point.