Tuesday, September 4, 2012

Expect Little From The ECB on Thursday

Thursday is the next ECB board meeting. Will Draghi be able to do “whatever it takes” to save Spain?

In order for the ECB to start buying Spanish bonds, there are three conditions precedent: (1) the ESM must be inaugurated, which requires the OK of the German constitutional court; (2) Spain must apply for aid from the ESM; and (3) Spain must sign onto a fiscal plan approved by the Troika, including the IMF.

I presume that the German court will OK the ESM. But Spain is not willing to even discuss making an application to the ESM.  PM Rajoy says that he doesn’t need to agree to an austerity plan, and that in any case he won’t apply until the ECB agrees to unlimited bond purchases.

Draghi is left with no room for manoeuvre. He can’t agree to unlimited bond purchases, and he can’t do anything at all for Spain until the government applies for aid. Draghi stands ready to buy Spanish bonds, but he can’t do it yet.

Rajoy knows that Spain is TBTF, and he is prepared to play chicken with Europe to get what he wants. He has no desire for the “men in black” to take over his country.

If I were Mariano Rajoy, I would be doing exactly what he is doing. He does not want Spain to walk the path of starvation in exchange for minimal life-support. He wants the ECB to bring Spanish bond yields down to an affordable level without having to impose austerity. If he gets his way, it will be better for Spain; the strategy of spending cuts chasing revenue shortfalls is disastrous.

This is a battle between the North (Germany, Finland, Netherlands) and the South (France, Italy and Spain), and the cockpit is the ECB governing council. On Thursday, I expect neither side to win. I have no idea who will win in the end, but I’m rooting for the South.

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