Though European Central Bank (ECB) president Mario Draghi had some disappointing clarifications to give on the ECB’s unlimited bond purchases of government bonds of troubled countries like Italy and Spain, the markets seem to believe his promise of keeping monetary policy accommodative was good enough. The euro rallied immediately, from $1.2994 late Wednesday to $1.3104 late Thursday and the FTSE Eurofirst 300 share index was up 2%, its highest level since early 2011. Draghi surprised many when he said the ECB wouldn’t be buying bonds unless countries were already in the market—implying that no country could afford to dismiss the discipline that being in the market implies. The larger reason why the markets have chosen to believe Draghi—though the ECB refused to cut rates despite the further contraction in Europe—is that there is a definite sign of improvement. There is, of course, a question over whether this will last in the face of large unemployment of 25% in Greece and Spain and much worse in the case of the youth. In the case of Spain, cheaper labour has encouraged automobile firms to raise production and for offshore call centres from Latin America to be relocated back in Spain—the current account deficit has virtually been wiped out from 10% of GDP in 2008. Even in the case of Italy, where bond yields rose after the elections, as Draghi pointed out, at 4.8% 10-year yields are much below last year’s peak of around 7%—Italy is expected to run a primary fiscal surplus of more than 3% of GDP this year. Two figures given by Draghi are worth keeping in mind. One, while the ECB injected more than 1 trillion euros through its long-term refinancing operations, around 40% of that has been repaid. Two, the euro area-wide government deficit has declined from 4.2% of GDP in 2011 to 3.5% of GDP in 2012 and further to a likely 2.8% this year. The surge of global liquidity, meanwhile, has ensured that with Italy’s high yields, holdings of government bonds by local banks and the ECB has risen from 50% of total Italian debt in mid-2011 to more than 65% today.
While Draghi used this to joke about Italian elections just being this week’s angst—one of the many Europe has had over the years—and argued that many of the deficit reduction policies of Mario Monti would continue on auto-pilot, the real danger lies in Europe’s continued contraction. While GDP in the eurozone contracted 0.6% in the October-December quarter over the previous one—Germany contracted 0.6%, France 0.3%, Spain 0.8% and Italy 0.9%—the ECB’s latest projection is a contraction of 0.5% this year, more than the 0.3% forecast just 3 months ago. Right now, with central banks from the US to Japan promising more liquidity, the markets are looking quite complacent. While Draghi’s promise in September to not let the euro collapse has removed the tail risk of the eurozone blowing up, the danger of politicians not being able to undertake more austerity is a real one as Greece enters its 6th year of contraction, Spain will shrink for the 4th time in 5 years and Italy the 4th time in 6 years. The markets seem to be ignoring the fact that a contracting economy means debt levels worsening—from 85% of GDP at the end of last year, Spain’s debt is forecast to rise to 101% of GDP by the end of next year.