Sunday, October 28, 2012

The Hellenics Play "Quien Es Mas Macho?"

For those who enjoy high-stakes financial drama, there is an exciting contest going on now between Cyprus and Greece as to who can push the Troika the furthest without turning it away for good. Neither country has yet been able to make the Troika “agree” to its “demands”, as if this were a business transaction between equals.

"The troika has not accepted the Democratic Left’s demands," the Greek finance minister informed the media. The DL, one of the coalition partners, has refused to agree to the labor reforms required by the Troika.

“The EU is obliged to change the ways and means of addressing the crisis,”  Cyprus president Dimitris Christofias grandly declared to his people, as if he had a say in the matter. The Troika got so frustrated with the Cypriots’ refusal to agree to labor reforms that it flew home and has not scheduled a return visit. Christofias said that he expected the troika to return "as soon as possible”. That was last week, and the Troika still hasn’t called him back to set a date.

Both countries are supposed to run out of cash in mid-November, so they are dancing on the edge of the precipice. They know that Europe will agree to almost anything to prevent them from leaving the eurozone, which they think gives them leverage.

They are playing a very risky game, because it isn’t Europe who has the final say on whether they get the money or not. That rests with the elected representatives of the very stingy German and Finnish people, who have reserved the veto power to themselves. A few emollient phone calls from Hollande or Monti, or a few desperate phone calls from Athens or Nicosia, are unlikely to sway many votes in Helsinki or Berlin.

The backdrop to these discussions is the fact that both economies are in free-fall, and that relying on their published statistics requires an act of faith that only a devout eurocrat could summon. I think that their economies are shrinking faster than reported; I think that their governmental cash receipts are declining rapidly despite tax hikes; and I think that their true fiscal deficits are frighteningly large and growing. I believe my deduction over their reported statistics.

If there is one thing that I learned in the credit business, it is that the financial statistics of bankrupt companies and countries always turn out to be, shall we say, not 100% accurate in retrospect. If you rely exclusively upon reported numbers, you may be seriously misled. Of course, in the case of Greece, it doesn’t take a Mensa member to know that they cook their books and prosecute  their statisticians for not cooking them adequately. In the case of Cyprus, I lack such anecdotal data, but I suspect the worst.

Anyway, D-Day is supposed to be November 12th, when the eurozone finance ministers meet in Brussels. The plan is that the Troika will have the Greek and Cypriot agreements in hand for the ministers to review. That is only ten business days from now, so suspense is starting to build.

We know that Merkel wants to present the Bundestag with a neatly-wrapped package deal for all of the bailouts at once: Greece, Cyprus, Spain. That can’t happen because the Hellenics need their money right now, whereas Spain hasn’t even applied yet. So Merkel will be forced to ask the Bundestag to OK the distasteful Hellenic deals on their own. That will be a bitter pill for the German people and media to swallow. Sadly, I am not an expert in Finnish politics, so I can’t handicap the parliament’s vote on the bailouts, but I have to imagine that they won’t pass by general acclamation.

Whose idea was it to give voters a say in such important matters?

Monday, October 22, 2012

Cyprus Could Explode Before Greece

“All of the political parties rejected the troika proposals for the abolition of    
CoLA, scrapping of the 13th salary, supervision of co-op banks by the Central Bank and the privatisation of semi-governmental organisations. When it came to drawing the ‘red lines’ the political parties were unanimous. None of the parties would dare disagree, because they would be publicly crucified for supposedly adopting the anti-worker positions of the troika and serving the interests of big capital.”
----Editorial in the Cyprus Mail, Oct.21st, 2012

“We know that we will not accept terms that will destroy the popular strata; abolish working peoples’ gains and sell off for pittance public property to big capital. We shall also stand on the side of the class-based trade union movement in the mobilisations it is planning if the Troika insists on its policies. That is to say, we shall not enter into a procedure that will negate us and that will be in complete contradiction with our ideology and history.”
---Statement by AKEL, the communist party of Demetris Christofias, the Soviet-educated president of both Cyprus and the EU, at the International Meeting of Communist and Workers' Parties, Brussels, Oct. 2nd, 2012

"Cyprus plans to contact international lenders on Monday evening to invite them to the island for final talks on a comprehensive aid package for the Greece-exposed island."
--Reuters, Oct. 22nd, 2012

I admit that I have been crying “wolf!” on the eurozone crisis for almost three years now, but I will now do it again. I think that the first country to  exit the eurozone may be Cyprus, and soon. Cyprus is a an economic, financial and political mess, worse than Greece, and it may not be too big to fail.

I have been following the Cyprus situation closely because Cyprus seems like the most scary sovereign credit in the eurozone. Cyprus has always had a powerful Communist Party, and it has always had a bit of an anti-western orientation, given its peculiar history (explained in Christopher Hitchen’s history of the island). Some may recall that Archbishop Makarios was viewed by the US as the “Castro of the Mediterranean” for his leftism.

In 2008, the people of Cyprus elected Demetris Christofias as president for a four-year term. Christofias, a marxist educated in Moscow during the Soviet period, headed the Cyprus Communist Party, known as AKEL. Earlier this year, Christofias became the president of the EU, which is not a purely ceremonial role.

I dare say that the Cypriot banks were never in terrific condition, given the nature of the Cyprus economy and the close relationship with Greece which has never been the “land of good loans”. However, the recent default by Greece on its government bonds and the collapse of the Greek economy have wiped out the Cyprus banks, which are now insolvent on an intergalactic scale. The cost of bailing out the Cyrus banking system is now estimated to be in the range of 100% of GDP. Some of that is worthless Greek bonds, some of that is bad loans in Cyprus and Greece, and some of it is not to be looked at too closely. One of the banks’ deadbeats is reportedly AKEL itself. Just don’t ask.

There is indeed an irony in that Cyprus needs a bailout from Big Capital at a time when it is led by a Communist, and that the EU, which is trying to figure out a way to bailout Cyprus, is headed by...Cyprus. But that’s not the problem. The problem is that Cyprus’ government, both president and parliament, are not cooperating with the Troika. Greece has learned to go through the motions of cooperation, agreeing to preposterous conditions it has no intention of implementing. Cyprus, by contrast, isn’t agreeing to any of the Troika’s demands (see the editorial in the Cyprus Mail above).

Cyprus needs the biggest bailout in the history of sovereign credit (100% of GDP), will run out of money next month, and yet continues to stonewall the Troika, not only in private but also in public. Christofias has reportedly said that “he would be out demonstrating with the unions” if the troika insisted on abolishing automatic COLAs for Cypriot workers. This could be face-saving political posturing before capitulation:  it is hard to sell austerity when you are the anti-austerity party.

I may be proved wrong next month as the Troika’s conditions are agreed and the bailout check is ultimately wired to Nicosia. Europe has many good reasons to want to get Cyprus over with in order to focus on Greece and Spain. The current EU plan is to bundle the bailouts of Cyprus, Greece, Spain and maybe Slovenia into one package for the German and Finnish parliaments to approve.

But there are still those two big hurdles: agreement to the austerity plan by Cyprus’ government and political parties; and approval by the German and Finnish parliaments. None of those will be automatic or even easy. In fact, there are reports that the Bundestag is turning against bailouts in general.

Default, debt repudiation and deposit redenomination would an interesting maneuver, as the Cyprus banks are stuffed with Russian and Chinese deposits (in euro).

Sunday, October 21, 2012

Foreign Policy Questions For Presidential Debate

Questions for the President:
Whom do you consider America’s most important strategic allies? Enemies?
Do you consider Israel to be an ally or a dependency?
Why did your government encourage Hosni Mubarak to leave office?
Has America’s strategic position in the region improved since the overthrow of Mubarak?
Why did your secretary of state boast about killing Muammar Qadaffi?
Why is the CIA supplying weapons to the Syrian uprising in the clear face of Russian opposition?
How would you characterize current US-Russian relations today?
If you could turn back the clock on the Arab spring, what would you have done differently?
Do you believe that Israel’s security could be guaranteed with a hostile and armed Palestine on both sides?
Do you believe that Arabs should be allowed to live in Israel?
Do you believe that Jewish settlers should be allowed to live in Palestine?
At what point would you draw the line with respect to the Iranian nuclear weapons program, such that you would consider a military solution?
Why is the US providing billions in aid to Pakistan including its military?
How would you characterize America’s economic and strategic relationship with China?
Why have you maintained the trade embargo with Cuba? What purpose does it serve?

Questions for Gov. Romney:
Do you support a Palestinian state on the West Bank and Gaza? If not, then what is your solution to the Palestinian problem?
How do your aggressive foreign policy goals square with the fact that Russia and China  have a veto on the Security Council?
What role do you see the Security Council playing in the conduct of foreign policy under your administration?
How many carrier battle groups do you think the Navy needs?
Which major defense procurement programs or other programs would you end?
What is your position on the $400 billion F-35 fighter program?
What are the reasons that you think the US should go to war the next time?
How many wars can the US be fighting at the same time?
Do you agree with the overthrow of the leaders of Tunisia, Egypt, Libya and Syria?
Would you prefer an elected Islamist to a secular dictator in the Middle East?
What do you see as the strategic role for NATO?
How big should NATO be?
Would you reduce the number of US troops stationed in Europe and Asia and the rest of the world?
Do you support membership in NATO for Ukraine and Georgia?
Would you go to war with Russia over Georgia’s breakaway republics?
Do you see any chance that the US could become a more “normal country” with respect to foreign policy?
What should be the limits to US intervention in foreign countries?

Friday, October 19, 2012

Who Will Lead The Revolt Against Germany?

“Mr. Hollande has sought to reduce Germany's dominance over Europe's anti-crisis strategy, and open up Europe's debate over solutions to other voices. Since Mr. Hollande's election victory over Mr. Sarkozy in May, France has tried to play the role of a broker between Germany and southern European countries, including Italy and Spain, which are seeking more-generous European help against recession and financial-market strains.”
---WSJ, “Summit Reveals Wider Franco-German Discord”, Oct. 19, 2012

That seems to be the main takeaway from the just-concluded EU summit: that Hollande has chosen to directly challenge Merkel’s leadership of the union. I interpret this in two ways: (1) the good news is that the needy South is building a political coalition against the cold-blooded North; and (2) the bad news is that the Southern coalition appears to prefer public whining to real political action. But I hope I am mistaken about that. Maybe they are biding their time.

Of the three Southern leaders, clearly the intellect is Monti. I think that he grasps the enormity of the problem facing Europe, including the need for reflation. But, because Italy is not yet in the direct line of fire, his strategy is to lay low and work behind the scenes. For now, he prefers to work on structural reforms to make Italy a better credit (with market access), rather than launching a frontal assault on Frankfurt and Berlin.

Hollande seems to have the guts to take on Germany, but I am not sure that he fully comprehends the need to actually depose Germany from its leadership position in the EU and the ECB. The last sixty years of French foreign policy have focused on bringing Germany in, not on pushing her out. That would be a big step.

Rajoy appears to me to be wholly out of his depth, but I am not really in a position to pass judgement on him yet. I agree with what he doing (demanding as much as he can get), but I doubt that he understands the urgent need to take over the governance of the ECB. He is the most radical, but he is not radical enough. Begging for a bigger IV drip will not save Spain. Only a revolution in the eurozone can do that.

But there is hope. These three men have enormous political power in Europe, and they should be able to craft a large bloc of sympathizers out of the 17 members of the eurozone. As the next few months demonstrate that Europe is facing a future of endless zero growth, and as each of them fail to hit their fiscal targets, one hopes that they will realize that, as Mrs. Thatcher would say, there is no alternative.

It is a shame that, aside from dear departed Sarkozy, no European leader has dared to question the baneful role of the ECB’s single mandate of price stability. That is the intellectual breakthrough which is needed. It is ironic that the breakthrough occurred in the US, which is not facing zero growth, rather than in the eurozone, which is becoming a textbook example of Fisher’s debt-deflation spiral.
Europe needs to stop being afraid of the Bundestag, the Bundesbank, and the Constitutional Court. They don’t rule Europe and they don’t even have a veto.

Wednesday, October 17, 2012

Moody's Keeps Spain At Investment Grade

Two weeks ago I commented on Moody’s rating on Spain, which was on review for downgrade:
“My guess is that the rating will go to Ba2 with a negative outlook. In my opinion, while Spain will be helped in the short-term by the eurozone’s “crisis-management framework”, it is doomed in the end to default and redenomination, as long as the ECB sticks to its price-stability suicide pact.”
(Spain On The Brink Of A Downgrade To Junk, Oct. 2nd, 2012)

My prediction was incorrect. Yesterday Moody’s confirmed Spain’s rating of  Baa3 in advance of Spain’s planned EUR 4.5B bond sale on Thursday. The rationale for the rating confirmation can be capsulized as follows:
Moody's believes that the combination of euro area and ECB support and the Spanish government's own efforts should allow the government to maintain capital market access at reasonable rates, providing it with the time it needs to stabilise public debt over the next few years. Ultimately, the Spanish government's ability to refinance maturing debt will depend on the credibility of its efforts to reduce its large fiscal deficit and reverse the rising public debt trajectory.”

The core element of Moody’s decision is that the ECB’s bond-buying program will enable Spain to maintain access to the private debt market as it slowly gets its fiscal house in order. Over time, Moody’s expects Spain to stabilize its debt trajectory and thus make it once again a creditworthy borrower on its own. Moody’s also believes that the ongoing bank recapitalization program will restore confidence in the banking system, presumably curbing deposit outflow. The risks cited by Moody’s are a lower growth outlook, a Greek exit, and insufficient ECB bond purchases to bring down yields.

As I indicated above, I take a more negative view than does Moody’s. This is because I see no hope for a stabilization of Spain’s debt trajectory as long as there is no nominal economic growth in Spain and the eurozone. It is very hard to grow government revenue in a zero nominal growth environment. In the recessionary world in which Spain lives, it is painful to raise government revenue while cutting social spending.

Moody’s is certainly right to say that the preservation of Spain’s market access “will depend on the credibility of its efforts to reduce its large fiscal deficit”. I am in no position to judge the resolve of the Rajoy regime in implementing austerity. Presumably they will have no choice, given the conditionality of the aid program. But I can say that imposing austerity on Spain in the midst of a recession will be deeply unpopular and not without controversy. Spain is not Finland.

What to expect going forward? Spain will next have to apply for aid from the Eurogroup and agree the terms. Then, the parliaments of Spain, Germany and Finland must approve the deal. (Yes, Finland too.) That needs to happen over the next month or so. If the bailout deal goes through, then the onus will be on Mr. Draghi to do “whatever it takes” to bring down Spanish yields. Rajoy has asked for a ceiling of a 2% spread over Bunds, versus the current 4%. That seems like a reasonable request to me. There is nothing to prevent the ECB from making it happen.

Monday, October 15, 2012

QE3 Has Started, Only It Hasn't

I think that I have figured out why the Fed’s balance sheet has not grown since the announcement of QE3. The reason is that the NY Fed’s Open Market Desk has been buying Agency MBS which, for some reason, has very long settlement periods (60-90 days). Almost none of these have hit the balance sheet yet. The desk’s buying pattern (found on the NY Fed’s website but not on the FRB’s)  is entirely consistent with the announced program for QE3, at $15-20 billion per week:
9/13-19: $17.5B
9/20-26: $20.0B
9/27-10/3: $19.3B
10/4-10: $15.0
= $71.5B

I have been incorrect in saying that QE3 hasn’t started yet; the order-placement has indeed started, but it hasn’t been paid for. The Fed has been buying on the Lay-Away Plan. This means that the Fed has already created demand in the market for agency MBS, but the monetary base won’t expand until the Fed actually buys the securities and creates the money to pay for them on the deposit side.

From a monetary policy perspective, I have been correct: the monetary impact of QE3 has not yet been felt, only the demand for agency securities. I don’t know the weekly volume in agency MBS, so I can’t assess how significant these $15-20B purchases are, but the agency market is a second order effect, and not a monetary one. (The Fed’s political cover for this operation is that it is helping Harry and Hilda Homeowner by lowering mortgage rates.)

While I have been wrong about the Fed’s dereliction of duty, I haven’t been wrong about the monetary impact of QE3: it hasn’t been felt yet. The first settlements have just begun, and will reach full force next month. The Fed’s balance sheet and the monetary base will start to grow by $40B/mo. Slow but not nothing, and mildly bullish for equities, ceteris paribus.

Saturday, October 13, 2012

IMF Calls On Germany To Allow Spain Bailout

There is a lot of drama going on at the IMF meeting in Tokyo this week. It is about Spain. The whole world is calling upon Europe to end the drama and bail out Spain now. The IMF added its highly influential voice to the chorus yesterday, with Lagarde saying that "the ESM and the OMT need to be deployed.” The head of the IMF’s financial department said that "the European Stability Mechanism and the bond purchase program of the ECB must be perceived by markets as real, not virtual.” Strong words.

The financial media report that Merkel has advised Spain not to apply because she can’t get an aid package through her side of the parliament. FM Schauble’s mantra is that “Spain has not asked for aid”, which is a bit disingenuous.

The Spanish media are not silent about this story. El Pais reported that “opposition from the ranks makes neither Merkel nor Schäuble interested in an early request for help from the Spanish government.” The paper reports that Merkel has the votes on the opposition side, but not on her side, and she doesn’t want to legislate without her own coalition: “They want to avoid a new bitter debate about billions in disbursements to eurozone partners, given the tense previous votes on Spain, Greece and the German contribution to the ESM bailout mechanism.”

Dow Jones reports that a vote on the Spanish bailout could split Ms. Merkel's coalition ahead of German national elections in fall 2013. “A growing number of conservative backbenchers are opposed to further taxpayer aid for other euro members.”

So, Spain needs a rescue soon, the IMF and EU governments want the matter addressed urgently, but Merkel can’t or won’t introduce a bill. 

Spain is not going to admit that it needs a bailout but can’t get one. FM De Guindos denies that there is a problem: "The instrument is real, not virtual. Because it is real, it is ready to be used at any moment. It is available. It is available in October, in November, in December.” He reiterated the bromide Spain doesn’t need a bailout, and that it is perceived as a good credit by institutional investors: "There is a much more optimistic sentiment now than a few weeks ago. There is interest for Spain's public debt." What else is he supposed to say?

Given that this stand-off has the IMF worried, it’s fair to say that it’s not an imaginary problem. However, Europe will continue to subvene further billions to Spain through ECB-funded bank purchases of government bonds, so nothing will happen soon.

In fact, next week Spain is planning to sell EUR3-4 billion in new bonds (to its banks, presumably). This sale will coincide with the EU summit in Brussels, where poor Mrs. Merkel will undoubtedly be the subject of much attention. I would not be at all surprised if the EU leaders have trouble drafting a consensus communique, as they did last time. I don’t see Hollande, Monti and Rajoy settling for more eurospeak about solidarity. There could be some drama then too.

Friday, October 12, 2012

The Bundestag Is Blocking Spain's Bailout

Here’s what we do know: the Spanish economy is imploding, government revenues are falling despite higher taxes, and the bank run continues. Spain is running out of runway, and something will have to happen.

Europe has told Spain that, if she applies for assistance from the Eurogroup and agrees to the Troika’s terms, the ESM will lend directly, and the ECB will buy Spanish bonds in the secondary market.  This would appear to be the obvious next step.

However, Spain has not yet applied for assistance, and has given three reasons for not applying. First, she says she doesn’t need the money, which is a blatant but understandable lie. Second, she says that she won’t apply until the Troika’s terms are known, and the ECB is more explicit about the size of its intervention in the bond market. Rajoy doesn’t want Spain to be living on an IV drip like Ireland and Portugal, and who can blame him? Thirdly, Spain will not apply for aid unless she can be assured of receiving it. That’s the really scary part.

According to Reuters:

“Germany has sent Spain strong signals that it should hold off because German Chancellor Angela Merkel is wary of presenting a fresh aid request to her parliament, euro zone sources say. Spanish officials see more risks to moving ahead quickly without assured German backing, than in delaying a request.”

There you have it: Even if Rajoy were satisfied about the terms of the deal he needs, he can’t apply because Merkel won’t put it before the Bundestag. Given all the happy talk in Brussels and Frankfurt about how Europe is moving forward to resolve the Spanish crisis, there is only one problem: the Bundestag. Nothing can be done for Spain or anyone else unless the Bundestag approves. Not all Eurozone parliaments, just one: Germany’s. The entire fate on Europe hangs upon the political calculus of one country’s legislature. That’s because of the rulings of the Constitutional Court.

I will admit that it is very unfair to Germany to put her in this very awkward position, where she alone has a veto over the Spanish bailout. Perhaps when General Clay was “helping” the Germans to write their constitution, he should have made it a bit less democratic.

Be that as it may, this is Europe’s latest problem: “The Germany that can say no”.  It is telling that Merkel and Schauble are telling Spain to wait. Presumably they hope that the Bundestag will be more accommodating when Spain is teetering on the edge of default. That’s reassuring.

It used to be that one thought that Rajoy was negotiating with Europe over Spain’s bailout. It is now clear that he is negotiating with the Bundestag, which is much less charitable. At this inopportune juncture, democracy decides to rear its ugly head.

Thursday, October 11, 2012

QE3's Market Impact Will Be Visible by Next Spring

Will QE3 raise stock prices? My answer is yes, but the impact will be quite small at first and will only become visible with the scale of its impact on the  Monetary Base (the Fed’s securities portfolio).

First of all, we need to recognize that the Fed’s balance sheet has not grown since May of 2011,  seventeen long months ago. There has been zero monetary stimulus for over a year. Second, we need to recognize that although the Fed promised to start QE3 on September 13th, it has not yet started. Don’t ask me why. I can imagine a number of (unsatisfactory) reasons why QE3 hasn’t started, but it hasn’t started. The Monetary Base is still the same size that it was in May, 2011. The Fed has provided no explanation for the one-month siesta.

Therefore, we can’t make any empirical statements about the impact of QE3 on the Dow, because there is no QE3 yet. Assuming that Bernanke gets his act together, QE3 should get started by the end of this month. The Fed’s announced schedule for QE3 was to buy $23B in September and $40B in October. That means they will need to buy $72B between now and the end of the month (since the MB has declined by $9B since the FOMC announcement). I’m not holding my breath; the Fed appears to be taking its public promises as very general guidance.

The amount, $72B, is peanuts, as it would represent an increment of only 3% on the Fed’s balance sheet. This is why the impact of QE3 will only be felt cumulatively, as the little bits start to add up over the next six months. Six times $40B is $240B, which would represent a 9% growth in the Fed’s balance sheet, which becomes more significant--but that’s next April. Even when QE3 gets started, it won’t be an adrenaline injection; more like a cup of coffee.

If there has been no bond-buying by the end of this month, I will expect an explanation!

Wednesday, October 10, 2012

S&P Takes Spain To The Brink Of Junk

S&P downgraded Spain today from BBB+ to BBB-, joining Moody’s at the bottom of investment grade, along with a negative outlook (obligatory these days).

Their summary rationale for the downgrade is as follows:

“(1) The deepening economic recession is limiting the Spanish government's
policy options. (2) Rising unemployment and spending constraints are likely to intensify social discontent and contribute to friction between Spain's central and regional governments. (3) Doubts over some eurozone governments' commitment to mutualizing the costs of Spain's bank recapitalization are, in our view, a destabilizing factor for the country's credit outlook.”

S&P is arguing that GDP will continue to decline; that the country’s governability is becoming ever more difficult; and that there is no assurance that the Eurogroup has the willingness or the ability to restore market confidence in the creditworthiness of the Kingdom or its banks.
S&P is particularly peeved that Europe reneged on its promise to provide ESM money to recapitalize Spanish banks. S&P must now add the cost of the bailout to Spain’s debt ratios.

S&P’s overall view is consistent with Moody’s and with my own, except that I am much more pessimistic. I do not view Spanish government bonds as an  investment suitable for widows and orphans, due to its many speculative elements. Spain belongs squarely in the Ba/BB category, because no matter what happens next, it won’t  transform Spain into a stable, investment-grade credit. And Spain will go to junk over the next month or two, you can count on it.

What is of interest in S&P’s extended rationale is the emphasis it places on governability, which is certainly warranted. As in both Greece and Italy, the government does not command the parliament, and cannot simply push through its agenda. The Rajoy government appears to be weak, and to be playing to the gallery rather than dealing with a national crisis. One can see Rajoy as being canny in refusing a bailout until it meets all of his (reasonable) demands, but that doesn’t make him a powerful leader in Spain. Time will tell on that score.

With regard to the inopportune resurgence of aspirations for regional independence, here’s what S&P has to say:
“With local elections approaching and many regional governments facing
significant financial difficulties, tensions between the central and regional
governments are rising, leading to substantially diluted policy outcomes.
These rising domestic constraints are, in our view, likely to limit the
central government's policy options.”

It is ironic that the regions are simultaneously demanding bailouts and independence, which takes the hispanic equivalent of chutzpah. This, as S&P observes, complicates the political challenge of uniting the nation behind an austerity program acceptable to the IMF.

S&P also expresses concern about the breakdown of the credit process in Spain due to bank deleveraging, with the price of credit for corporates becoming prohibitive, and the availability of credit for SMEs disappearing. As we know, when credit flows remain blocked, the heart stops beating.

S&P gives Rajoy no credit for his policy of refusing to apply to the Eurogroup until he knows what he’s going to get and what he has to do to get it. They say:
“We view the Spanish government's hesitation to agree to a formal assistance program that would likely significantly lower the sovereign's commercial financing costs via purchases by the ESME and ECB as potentially raising the downside risks to Spain's rating.”

I don’t agree with that sentiment. In my view, Rajoy is smart not to make Ireland’s mistake by agreeing to drink poison in exchange for life-support. He needs a free bailout of his banks, an ECB deposit guarantee, unlimited ECB purchases of  government bonds, and reflation. If all he is offered is pocket change, he should hold out until he gets what he needs, and I applaud that. That is the only way for Spain to avoid eventual default.

There is no evidence in S&P’s commentary or Moody’s that they fully understand the hopelessness of the PIIGS’s outlook as long as price stability remains ECB policy. No amount of austerity and bailouts can restore economic growth. As long as the denominator in D/GDP is declining, the only way to stabilize the ratio is to impose losses on bondholders. That is much more costly than 5% inflation.

S&P and Moody’s are correct in observing that Spain’s credit is deteriorating. What they don’t grasp is that, under present circumstances, there is no way to avoid creditor losses. It’s already happened in Greece which was, of course, “unthinkable” until it happened.

Tuesday, October 9, 2012

Paging Mr. Bernanke: QE3 Is Too Small

I was a bit over-enthusiastic in my positive reaction to the announcement of QE3+. I was excited by the fact that the Fed was finally targeting an output (employment) instead of an input, and that no limit was set for the amount of expansion required to achieve the target.

As I have run the numbers, however, my enthusiasm has diminished. This is because, aside from the fact that the program has not yet started, the programmed pace of expansion is too low. While there is no ultimate limit on the amount of MBS purchased, the amount to be purchased each month is just too small to get things going.

I say this because QE3 is much smaller than QE1 or QE2. This is true in both an absolute and a relative sense:
QE1 lasted for about six months from the fall of 2008 until the spring of 2009. The Fed bought about $1 trillion in bonds, growing its balance sheet from $800 billion to about $1.8 trillion, an increase of 125%. That was huge.
QE2 lasted for about six months from late 2010 until mid-2011. The Fed bought about $700 billion of bonds, growing its balance sheet from $2 trillion to $2.7 trillion, an increase of 35%, much smaller than QE1.

QE3 is supposed to last until the Fed’s definition of “full employment" is achieved. However, by pacing the expansion at $40 billion per month, even a one-year program will not be big enough. At $40B/mo. for one year, QE3 would be a $500 billion program, for an increase of only 17%. That just isn’t going to cut it.

There should be no limit on the amount of monthly bond-buying, and the program should be front-end loaded with purchases of at least $200B/mo. which is closer to the pace of QE1. There is little risk of overshooting the employment target or of kindling excessive inflationary expectations.

The Fed left open the possibility of a faster pace of expansion:
"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases."

That suggests to me that the program could be expanded next year. So far, the Fed’s buying program is in arrears, as its MBS portfolio has been shrinking instead of growing. The FOMC pledged to buy $37B in MBS by Oct.11th, and to continue to reinvest proceeds from its existing portfolio. The portfolio stood at $844B at the time of the announcement, which suggests that by Thursday the portfolio should be $881B. That would require the Fed to buy $46B of MBS this week, which isn’t likely. So they will have to work a little harder for the rest of the month.

The Fed owes us a report on Thursday or Friday of this week:
“In order to ensure the transparency of its MBS transactions, the New York Fed will publish historical operational results at the end of each monthly period  [beginnning Oct. 11th]. Operational results will include agency MBS transactions associated with both the additional asset purchases announced by the FOMC on September 13, 2012, and purchases related to the reinvestment of principal payments from agency debt and agency MBS in agency MBS.”

So it won’t belong before we know what the story is with the delay in implementing QE3 and what they plan to do about it. It will take a few months before the Fed will be able to judge the efficacy of the program. I would add that, should anything bad happen between now and then (Greek default, stock market crash), Bernanke will undoubtedly hit the accelerator.

Saturday, October 6, 2012

QE3: What's The Holdup?

“The purchases of additional agency MBS will begin tomorrow (9/14), and are expected to total approximately $23 billion over the remainder of September.”
--FOMC Statement, Sept. 13th, 2012

The Fed published the above statement on September 13th. As of that date, the Fed held $844 billion of MBS. $844B plus $23B in new purchases should result in an MBS portfolio of $867B. As of Oct. 3rd, the Fed’s MBS portfolio stood at $835B, a shortfall of $32B. Inexplicably, the Fed now has an MBS deficit of $35B. Almost a  month after the announcement of QE3+, nothing has happened, despite the Fed’s promise to start buying “tomorrow”. (By the end of October, the Fed’s MBS portfolio should be $907B, a gap of $72B from today.)

Obviously, this is some sort of screw-up. There is no valid reason that I can think of why the Fed is selling MBS when it has said that it will be buying it.
The whole point of using transparency to manage expectations is that public statements are reliable, not aspirational. Now it appears that we will need to decide in future which of the Fed’s forward-looking statements are sincere and which are whimsical.

It is ironic to see so many pundits now saying that QE3+ hasn’t worked, when it hasn’t started yet. My prediction is that Bernanke will get his act together in the next two weeks, and the OMO desk in New York will in fact start buying MBS, and that these purchases will not be sterilized by selling other assets. When this happens, there should be a gradually swelling impact on the monetary base, the money supply and, more importantly, inflationary expectations. This should be bullish for equities, because it will mean faster nominal and real growth.

Presumably, at some point the “transparent” Fed will explain to us why it chose to delay its buying program by three weeks and counting. If there is an explanation somewhere on the Fed’s website, I can’t find it. On the NY Fed’s website under Open Market Operations/MBS, it states that “During the period of July 22 to September 30, 2010, no transactions of this type were conducted.”

This is indeed a mystery, which one hopes will be resolved quickly.

Thursday, October 4, 2012

Southern Europe Must Revolt Against Price Stability

It’s time for a revolution in the eurozone; the time for polite discussion has ended. What is at stake is not a percent or two of economic growth in the South, but rather the difference between a future of prosperity and a future of depression. The mindless happy talk of unity, solidarity and an ever closer union is now irrelevant and in bad taste. People are eating out of trash bins, and an entire generation is living on the dole.

If the South continues to permit the North to administer the poisonous medicine of monetary deflation and fiscal austerity, it will suffer needlessly for years. Yes, we all know that the ECB was modeled after the Bundesbank and part of the deal for Germany was that the euro would be as strong as the mark. But that was then, and this is now.

The eurozone is a multinational republic in which no country, no matter how high its credit rating, can act as hegemon. Germany has just two votes on the ECB’s governing council, not control and not a veto. Germany is  just another member of the union, and the Bundesbank is just another regional branch of the Eurosystem. The ECB treaty was not intended as a suicide pact, and it can be interpreted liberally enough to permit what has to be done. If the constitutional court objects, then Germany can exit. She can’t force anyone else to.

The revolution must be led by France, Italy and Spain. They have already acted together at the last summit, when Monti refused to adjourn until Merkel made major concessions (since rescinded) about bank bailouts. These three men, Hollande, Monti and Rajoy, must form the nucleus of a bloc within the eurozone that demands open-ended QE until eurozone nominal growth rises to the mid-single-digits, and stays there.

First of all, there may already be enough votes on the governing council to ram QE through the Berlin Wall. Failing that, the bloc can refuse further austerity and threaten exit unless the ECB capitulates. Sadly, Mario Draghi is a cipher in all this, having sworn allegiance to the single mandate in order to get Merkel’s approval as president. He cannot lead the rebellion, nor would it be appropriate for him to do so.

What I am advocating is a public break with the Bundesbank and its ideological satellites, and a categorical rejection of minimal nominal growth and fiscal retrenchment. The Southern Bloc must demand nominal growth targeting, unsterilized bond-buying, and an end to self-strangulation by austerity. Those policies have been tried and they have failed for two years.

The South cannot balance its budget without inflation, nominal growth, and rising nominal government revenue. Structural reform is nice but at this stage quite irrelevant. Budget cuts and labor market reforms are not and must not be a prerequisite for nominal growth. Those are shibboleths unrelated to medium-term growth, and they would be much easier to implement in the context of growth.

Before this heart-rending tragedy is over the South will revolt, but probably when it is too late. The time is now, before Spain and Italy are forced to drink the Troika’s strychnine and arsenic. France, as a continental leader with market credibility, must lead this effort. Germany and its allies will think twice before going mano a mano with France.

The cost to the creditor powers will be higher inflation and a decline in value of their claims on the South, but that must occur one way or another. Inflation is much preferable to repudiation, which is the only other viable alternative.

Maybe it would be more prudent to conduct this revolt in private, but my sense is that it can only work as a public ultimatum. Europe successfully stared down Russia on many occasions during the cold war; she can do the same with Germany today.

Transcript Of Draghi's Press Conference Today

For the convenience of readers, I have cleaned up the ECB's transcript of Draghi's press conference today, which followed the monthly meeting of the governing council.

Introductory statement to the press conference and subsequent Q&A

Mario Draghi, President of the ECB,

Slovenia, 4 October 2012

Ladies and gentlemen, the Vice-President and I are very pleased to welcome you to our press conference. I would like to thank Governor Kranjec for his kind hospitality and express our special gratitude to his staff for the excellent organisation of today’s meeting of the Governing Council. We will now report on the outcome of today’s meeting.

Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. Owing to high energy prices and increases in indirect taxes in some euro area countries, inflation rates are expected to remain above 2% throughout 2012, but then to fall below that level again in the course of next year and to remain in line with price stability over the policy-relevant horizon.

Consistent with this picture, the underlying pace of monetary expansion remains subdued. Inflation expectations for the euro area continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term.

Economic growth in the euro area is expected to remain weak, with ongoing tensions in some euro area financial markets and high uncertainty still weighing on confidence and sentiment.

Our decisions as regards Outright Monetary Transactions (OMTs) have helped to alleviate such tensions over the past few weeks, thereby reducing concerns about the materialisation of destructive scenarios. It is now essential that governments continue to implement the necessary steps to reduce both fiscal and structural imbalances and proceed with financial sector restructuring measures.

The Governing Council remains firmly committed to preserving the singleness of its monetary policy and to ensuring the proper transmission of the policy stance to the real economy throughout the euro area. OMTs will enable us to provide, under appropriate conditions, a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area. Let me repeat again what I have said in past months: we act strictly within our mandate to maintain price stability over the medium term; we act independently in determining monetary policy; and the euro is irreversible.

We are ready to undertake OMTs, once all the prerequisites are in place. As we said last month, the Governing Council will consider entering into OMTs to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected. We would exit from OMTs once their objectives have been achieved or when there is a failure to comply with a programme. OMTs would not take place while a given programme is under review and would resume after the review period once programme compliance has been assured.

Let me now explain our assessment in greater detail, starting with the economic analysis. Euro area real GDP contracted by 0.2%, quarter on quarter, in the second quarter of 2012, following flat growth in the previous quarter. Economic indicators, in particular survey results, confirm the continuation of weak economic activity in the third quarter of 2012, in an environment characterised by high uncertainty. We expect the euro area economy to remain weak in the near term and to recover only very gradually thereafter.

The growth momentum is supported by our standard and non-standard monetary policy measures, but is expected to remain dampened by the necessary process of balance sheet adjustment in the financial and non-financial sectors, the existence of high unemployment and an uneven global recovery.

The risks surrounding the economic outlook for the euro area continue to be on the downside. They relate, in particular, to ongoing tensions in several euro area financial markets and the potential spillover to the euro area real economy. These risks should be contained by effective action by all policy-makers in the euro area.

Euro area annual HICP inflation was 2.7% in September 2012, according to Eurostat’s flash estimate, compared with 2.6% in the previous month. This is higher than expected and mainly reflects past increases in indirect taxes and euro-denominated energy prices. On the basis of current futures prices for oil, inflation rates could remain at elevated levels, before declining to below 2% again in the course of next year.

Over the policy-relevant horizon, in an environment of modest growth in the euro area and well-anchored long-term inflation expectations, underlying price pressures should remain moderate. Current levels of inflation should thus remain transitory and not give rise to second-round effects. We will continue to monitor closely further developments in costs, wages and prices.

Risks to the outlook for price developments continue to be broadly balanced over the medium term. Upside risks pertain to further increases in indirect taxes owing to the need for fiscal consolidation. The main downside risks relate to the impact of weaker than expected growth in the euro area, in the event of a renewed intensification of financial market tensions, and its effects on the domestic components of inflation. If not contained by effective action by all policy-makers in the euro area, such intensification has the potential to affect the balance of risks on the downside.

Turning to the monetary analysis, recent data confirm the subdued underlying pace of monetary expansion. In August the annual growth rate of M3 decreased to 2.9%, from 3.6% in July. While this decline was mainly due to a base effect, monthly inflows were also relatively contained. Conversely, strong monthly inflows into overnight deposits contributed to a further increase in the annual rate of growth of M1 to 5.1% in August, compared with 4.5% in July. This increase reflects a continuing high preference for liquidity in an environment of low interest rates and high uncertainty.

The annual growth rate of loans to the private sector (adjusted for loan sales and securitisation) declined in August to -0.2% (from 0.1% in July), reflecting a decrease in the annual rate of growth of loans to non-financial corporations to -0.5%, from -0.2% in July. By contrast, the annual growth of loans to households remained unchanged, at 1.0%, in August. To a large extent, subdued loan dynamics reflect the weak outlook for GDP, heightened risk aversion and the ongoing adjustment in the balance sheets of households and enterprises, all of which weigh on credit demand. At the same time, in a number of euro area countries, the segmentation of financial markets and capital constraints for banks restrict credit supply.

The soundness of banks’ balance sheets will be a key factor in facilitating both an appropriate provision of credit to the economy and the normalisation of all funding channels, thereby contributing to an adequate transmission of monetary policy to the financing conditions of the non-financial sectors in the different countries of the euro area. It is thus essential that the resilience of banks continues to be strengthened where needed.

To sum up, the economic analysis indicates that price developments should remain in line with price stability over the medium term. A cross-check with the signals from the monetary analysis confirms this picture.

Other economic policy areas need to make substantial contributions to ensure a further stabilisation of financial markets and an improvement in the outlook for growth. As regards fiscal policies, euro area countries are progressing with consolidation. It is crucial that efforts are maintained to restore sound fiscal positions, in line with the commitments under the Stability and Growth Pact and the 2012 European Semester recommendations. A rapid implementation of the fiscal compact will also play a major role in strengthening confidence in the soundness of public finances.

At the same time, structural reforms are as essential as fiscal consolidation efforts and measures to improve the functioning of the financial sector. In the countries most strongly affected by the crisis, noticeable progress is being made in the correction of unit labour cost and current account developments. Decisive product and labour market reforms will further improve the competitiveness of these countries and their capacity to adjust.

Finally, it is essential to push ahead with European institution-building. The ECB welcomes the Commission proposal of 12 September 2012 for a single supervisory mechanism (SSM) involving the ECB, to be established through a Council regulation on the basis of Article 127(6) of the Treaty. The Governing Council considers an SSM to be one of the fundamental pillars of a financial union and one of the main building blocks towards a genuine Economic and Monetary Union.

We will formally issue a legal opinion in which we will, in particular, take into account the following principles: a clear and robust separation between supervisory decision-making and monetary policy; appropriate accountability channels; a decentralisation of tasks within the SSM; an effective supervisory framework ensuring coherent oversight of the euro area banking system; and full compatibility with the Single Market framework, including the role and prerogatives of the European Banking Authority. As the Commission proposal sets out an ambitious transition schedule towards the SSM, the ECB has started preparatory work so as to be able to implement the provisions of the Council regulation as soon as it enters into force.

We are now at your disposal for questions.

Two short questions, Mr Draghi. The first one: you mentioned downside risks to the economy again. Have there been any discussions today about a possible rate cut in the months to come?
And the second one on Spain: do you find Spanish bond yields appropriate at the moment or are they still hampering your monetary policy transmission?

On the first question the answer is no and on the second question, I will not comment.
But let me say one thing I forgot; Marko will answer questions about Slovenia today, so you will have to ask him about Slovenia.

Mr Draghi, was the decision to leave rates unchanged unanimous? That is the first question.
And the second is: what do you think about publishing the minutes much sooner than 30 years after the respective meetings?

On the first question, I would say that there was no discussion. So it was a unanimous decision about interest rates.

On the second question, clearly there have been statements by several Governing Council members and by myself showing an open mind with regard to this point; but it is a complex process and we are actually thinking about how to proceed. There are pros and cons. What you have to keep in mind is that the ECB is already a very transparent institution; just think about this press conference every month. There are also hearings in Parliament, interviews, speeches… I think that there are some benefits, as far as communication is concerned, to having greater transparency. At the same time, we have to evaluate and assess what this means in our specific context, the European context, which is different from that of the United States and the United Kingdom.

Mr Draghi, last month when you announced the OMTs, you said that matters were now effectively in the hands of governments. How concerned are you by the way that governments have responded? Some finance ministers have suggested that the ESM might not be covering legacy bank debts for instance, and Spain has still not applied for a bailout.
And my second question is on Greece: how would the ECB feel about rescheduling the repayments on the Greek bonds? Would that qualify as monetary financing?

On the second question, the answer is yes, it would qualify as monetary financing. We have said several times that any voluntary restructuring of our holdings would be monetary financing.

On the first question, I could say that today we are ready with our OMTs. We have a fully effective backstop mechanism in place, once all the prerequisites are in place as well. Governments have made substantial progress on a variety of fronts, both in what I call “vulnerable countries” and in countries that are under a full IMF programme. You can actually see this progress across the board as far as fiscal consolidation, structural reforms and also repairing some of the flaws of the banking sector are concerned. So, at this point, it is really up to the governments to decide what they want to do. The mechanism is in place.

Now to your question about the ESM: we will have to assess exactly what it means, and I do not want to prejudge the technical discussion that will take place. But we have to remember that this is not a matter for the ECB, it is a matter for the governments concerned; it is governments’ money, it is taxpayers’ money. So, they will have to discuss and take a stance on exactly what is meant by legacy assets.

Back to the OMT, you mentioned that there are steps that need to happen before the ECB would activate it. It is in the governments’ hands. Does that weaken the effectiveness of the OMT because you make yourselves part of the political process, which can be time-consuming and complicated?

And my second question is on the continued rise in youth unemployment in Europe and anti-austerity protests. How concerned are you about unemployment, youth unemployment and is austerity making the problem worse? Thank you.

The first question is about conditionality. We view conditionality as an essential part of the activation of the OMT. I have made this point since the very beginning. Conditionality will actually have several roles. First of all it will reduce the moral hazard by governments. The second role it will have is that it protects the independence of the ECB. Without conditionality you would certainly have what people call fiscal dominance. With conditionality the independence of the ECB is protected. There is also a third angle to this. You can look at conditionality as a way to create credit enhancement on the bonds of the country that is actually the object of conditionality. So, it is an incentive to pursue the right economic policies, which have benefits for all parties concerned. Now, there are going to be, and rightly so, some political processes, but look at this from another angle. You know that one of the conditions is the signing of a memorandum of understanding with the Eurogroup. Once you have that, you have unanimity. And you have the whole of Europe that is supporting this programme politically. By itself, this is an extremely forceful ingredient in the programme.

The second question was about youth unemployment. We completely share the concerns of the situation. And, as a matter of fact, in independent speeches several members of the Governing Council have raised the issue of high unemployment and especially focused on youth, on the young part of the population. It is an incredible waste of resources and it will have to be addressed and it can be addressed by properly reforming the labour market so as to decrease the dual nature the labour markets have taken, I would say in the last seven to ten years, in some European countries. The challenge, of course, is to address the dual nature of the labour market, while keeping it flexible overall.

Would a rate cut even be conceivable at the moment given that the transmission mechanism is broken and would there be any point in conducting such a thing until the OMT has been used or there has been a sustainable and significant drop in the bond yields of the countries that have distressed bond markets? Or is that an over-emphasis of the way you see this broken transmission mechanism?

And my second question. We are in Slovenia, at the spot where George W. Bush had his first ever summit with Vladimir Putin, after which Bush said he looked into Putin’s eyes and could see his soul and knew this was a man he could do business with. I was wondering if there was any such moment today between you and Mr Weidmann?

I would like to know from you who is Putin and who is George W. Bush?
I leave that to you.

On the first question, in a sense it is a purely hypothetical question. But it can be addressed by saying that non-standard monetary policy measures are being designed and implemented when the standard ones are not fully effective. Otherwise, we would simply stay with the standard policy measures. So, in a sense, this answers your question.

Can you carry on using standard measures at the same time as having to deploy non-standard ones?

Well, we have to see if we can repair the monetary policy transmission channels. We do not speculate on future changes in interest rates. I think that the Governing Council has assessed that the price level and the rate of change of prices is in line with medium-term price stability, according to our definition. So, that is the assessment we made about the interest rate and, as I said, there was no discussion.
But to answer your second question, while I do not want to comment on individual positions, of course, I can say that the discussion was very constructive across the board.
Mr Draghi, you keep encouraging banks to repair their balance sheets. Do you think that they should be able to use ESM funds for that, for their existing problems as well?
And my second question regards Spain: do you think that precautionary credit lines for Spain should be sufficient to solve Spanish financial problems?

On the first question: when I said there has been significant progress, I included the repair of bank balance sheets. The statement the President of the European Banking Authority (EBA) gave yesterday, when he presented the figures on the recapitalisation that has taken place so far, was reassuring in this respect. So, the capitalisation gap that was rather large until two years ago has been reduced significantly by the euro area/ European banks.
On Spain: it is one example where significant progress has been made. Significant challenges remain ahead as well, but the progress made on the front of fiscal consolidation, structural reforms (with the announcement of a very large reform programme), and on the front of the banking sector, with the conclusion of the stress test, is really remarkable if you think of just how many measures have been announced, legislated and implemented in such a short period of time.

Mr Draghi, just to follow up on that question. Does that mean that it would be enough for Spain to continue on its reform progress for the ECB to start buying bonds or would Spain actually have to commit to much harsher reforms for you to intervene?
And my second question would be: about a year ago, you said in a similar press conference that you would make periodic checks on whether you are in sync with the tradition of the Bundesbank or whether you are deviating from it. I was wondering what your assessment is today, whether you are in sync, or how close are you?

On the second point, I can answer right away that if the tradition of the Bundesbank was to ensure price stability, the ECB is fully in sync with that tradition.
On the first question, there is a tendency to identify conditionality with harsh conditions, as you said. Conditions do not necessarily need to be punitive. Actually, many of the conditions are related to structural reforms, which have social costs, but also great social benefits. And if the reforms are well designed, the latter are going to be greater than the former. So, whether this is enough is up to the Spanish Government to decide. It is for the other euro area governments to decide whether the programmes suffice – you know what the conditions are, you know that it is necessary to submit a request for an EFSF/ESM programme. We would actively seek the IMF’s involvement in the process. Having said that, we now have a mechanism in place that is a fully effective backstop if such a request comes and if the assessment of the Governing Council regarding the monetary policy transmission channels allows action to be taken.

I was wondering whether you could explain your thinking with regard to Portugal, because Portugal does look as if it has fulfilled the prerequisites for the OMT to work. So, why hasn’t the European Central Bank bought Portuguese debt on the secondary market?
And then one other question, because we are in Slovenia: the Slovenian Government is going ahead with the setting up of an institution to take over the non-performing loans from the banks in return for providing them with government bonds. Will those government bonds be eligible as collateral if the banks present them?

Portugal is an example of the significant progress that I have hinted at before, of the very, very significant progress that has been achieved. Moreover, the overall situation, politically speaking, is a strong situation. Obviously, we also fully share the concerns that have been expressed about the difficult social situation, but the reform agenda is firmly in place. The OMT would not apply to countries that are under a full adjustment programme until – and that is what I believe I said last time – until full market access, complete market access has been obtained. And this is because the OMT is not a replacement for a lack of primary market access. By the way, on this front, among several pieces of positive news that we have had in the last few days, we had one piece on Portugal, namely that, yesterday, for the first time, a three-year bond was issued, which is not complete market access, but it marks the beginning of complete market access, so that it is actually a reassuring bit of news.

On Slovenia, you are right. The Parliament has adopted a law on the agency that will try to carve out bad assets from the banks. But the precise modalities for the eligibility of these bonds has not been decided yet, so that I am not able to tell you whether this would be acceptable or not. I can only tell you that the pool of collateral that is available to Slovenian banks at the moment is sufficient and that it is not an urgent matter. I understand that it will be elaborated in further steps on this law.

Have you seen any signs that the pure announcement of the OMT framework has affected the easing of credit conditions in the weak countries?
And my second question is, have you discussed what could be a good measure to decide what is an acceptable level of financial fragmentation and what is an unacceptable level?

On the first question, the answer is yes.

Sorry, because the figures of today, the August figures, show that especially in Spain it is getting worse.

There was a substantial, significant improvement all across financial markets and then there was a correction. If we take a snapshot now with respect to the beginning of August we see that the various interest rate spreads are still at a level way below where they were in July. We see one comforting piece of news, as I said before, about Portugal, having issued the first three-year bond. The second piece of good news actually concerns Spain, that Spain has completed almost 90% of its funding programme for the sovereign. There has been sizeable issuance by corporations and banks since then and, something that is dear to our eyes and we always look at: TARGET2 balances (or imbalances) have stabilised. All in all, the effect has been positive. There have been sizeable inflows of bank deposits in Italy. Spain’s recourse to central bank financing has gone down in the last month. Not bad, but at the same time we also have to express a note of caution. First of all, volatility is still relatively high and, secondly, governments will have to persevere in their reform action on all fronts: fiscal consolidation, structural reforms, the banking sector and more generally the financial market sector.
What is an acceptable level of fragmentation? Well, it is hard to say. But certainly when you see two subsidiaries of the same company located in two different countries and paying completely different interest rates for their borrowing, when you see exactly the same individual borrower, say a young couple that wants to buy a flat, and paying a completely different interest rate on mortgages, then you start asking yourself, maybe there is a problem here. Then you look around and you see that credit flows are normal in one part of the euro area, are non-existent in another part, falling and have been falling precipitously in yet another part. When you see that you have widespread credit rationing in some parts of the euro area, when you see that there is a very strange correlation between the movements in the exchange rates and the interest rates; namely that the exchange rate appreciates when the interest rates go down, and vice versa. When you see that the bid-ask spreads reveal a profound lack of liquidity in certain markets, when you see that levels of volatility are abnormally high and when you see that you have the inversion of the yield curves all of a sudden, which then disappears right after an announcement, then you say that you have a reasonable and possibly unacceptable level of fragmentation in the euro area. But the issue is really that the level of fragmentation becomes unacceptable when the singleness of the monetary policy in the euro area is being put into question. Because that is the time when we cannot achieve our primary objective, namely maintaining price stability in the medium term across the euro area.
I would like to return to the question of bad banks. The ECB had some concerns regarding the establishment of this agency or bank and I would like to ask you,
Mr. Draghi, whether this remark still stands or you support this, let’s say, resolution for Slovenia?
And the second question is, what are your recommendations for Slovenia regarding fiscal consolidation? Do you think that Slovenia needs a bailout?

I think Marko will respond best to both questions, but by and large let me say that we agree with the overall assessment of the IMF.

Just to say a few sentences. The ECB made an assessment of the law that was adopted and we understood it in a sense that the view was that the agency, the government and the central bank should cooperate closely in deciding how to make the banking sector more resilient.
As to the second question regarding the bailout, I think it is much too early to say anything about it. All macroeconomic indicators at the moment point to the fact that if a country adopts decisive stabilisation measures in fiscal consolidation, in labour markets, in pension reforms and of course in the banking sector, it will not need to apply for a programme, but in the end, as the President also said, in many countries that is primarily a political decision. The central bank cannot operate in an environment which is inherently unstable from a macroeconomic point of view.

As a member of the Slovenian press, my question is rather similar. The decision on the OMT programme has contributed enormously to calming the situation in the markets. However, the yields on Slovenian government bonds remain rather high and surpass the yields of the Spanish government bonds. What do you believe are the factors that could calm this situation, which is very worrisome for Slovenian citizens?

The spreads that you have noticed in the markets in our opinion do not reflect the fundamentals. You should take into consideration that the capital markets for Slovenian paper are very shallow, the transactions are rare and one cannot judge the underlying fundamentals from two or three transactions. We believe that with the adoption of the stabilisation measures that I mentioned before, spreads will go down and I understand – no I do not only understand, you can verify yourself – that spreads have gone down. With the adoption of further measures I believe that spreads will go down as they have done in other euro area countries.

Two questions. The first one: How concerned are you that if the OMT programme actually comes into action it might rearrange the yield curve and denaturalise the yield curve, as it were and frontload the short-end of the maturity spectrum?
The second one is on the OMT per se: If the OMT is a purely monetary measure for repairing the dysfunction of a fragmented market, how can you set political preconditions? Is it not a little bit like the local fire brigade telling me “ I can only turn on the water if you show me that you have a roof improvement programme”?

On the first point, we will certainly monitor the strategic response of the issuers to our programme. The OMT is not meant to induce a strategic response in favour of issuing short terms.. So this will be monitored. By the way, I think, and that is my purely personal perception, that all of the countries that may need an OMT have now reached, after many years of a difficult, very difficult process, reasonable maturities, reasonable durations in their stock of public debt. It is very unlikely they will change these durations in favour of a short-term issuance. First, because they have market access. It is not that they do not have market access. These countries do have market access. So there is no reason really to change the duration, and you know there are not only pros if you change the duration, you also have some serious cons. So all in all, I think it is unlikely. In any event the ECB will closely monitor this possible strategic response by issuers.
As to the second point, I think it is just the other way around. I think I did say something about this last time we had this press conference. When the OMT was designed, we had the perception and the evidence that there were tail risks in the euro area, namely that there was a bad equilibrium for certain countries in certain markets. It means that expectations were self-perpetuating and in the end would create disruptive scenarios. So then it is opportune for the policy-maker, which in this case is the ECB, to step in with a programme. At the same time, we should not forget how these countries got into a bad equilibrium to begin with, namely with bad policies, or in some cases no policies at all for a long period of time, while the rest of the world was changing completely. So the first conclusion was that any monetary policy would have no effect if the other policies did not change. That is why conditionality is so important. Eventually, as I said at the beginning, it is what makes the monetary policy effective and it is what protects the independence of the ECB. So I would not buy the example you have given, I think it is really an integral part of this.

Are you comfortable with the current situation in which Spain – and even Germany – has doubts about the rescue? Or did you expect a more rapid reaction from the political side?
And second, do you think that Spain has the possibility to resolve its crisis without European aid?

Unfortunately, I cannot comment on either of the questions, because stopping this process is very much a decision that is entirely in the hands of governments. As I have said over and over again, I think that through the OMT programme, the ECB has done everything possible and it could certainly create an environment which is conducive to reforms because it could remove what we call the redenomination risk. So, it could remove tail risks but ultimately, the initiative is in the hands of governments.

You spoke several times about risks and now redenomination risks. Yields have calmed down since your announcement in July and then your further announcement. How much of these risks have been removed and do you think it is just a temporary effect which will be reversed in the event that the OMT programme is not applied?
And second, as you made OMTs dependent on a request and the governments seem to be extremely reluctant to make such a request, and given that the monetary policy transmission mechanism is still broken, have you thought about any other solution that you could apply in this event?

Well, on the second question: for the time being, no. I think we have the sense that it was a very important decision which has many dimensions. We had to cope with all of these and it is now in place. We are ready and we have a fully effective backstop mechanism in place. Now it is really in the hands of governments and, as I said many times, the ECB cannot replace the action of governments.

With regard to whether the level of interest rates reflects redenomination risks, as I said before, we are considering a variety of indicators here, one of which is the interest rates and then we are also considering those I mentioned, namely the bid-ask spreads, liquidity, the shape of the yield curves and volatility. So there are a variety of indicators which will certainly inform our monetary policy assessment.

With regard to the recapitalisation of banks through the ESM, do you see any possible way out and if so, what is it?
And second, the markets are already discussing the point at which you could intervene in the markets in the event that Spain or another country asks for aid. Do you have a particular target or target range?

On the second question, the answer is no. As I just said, we are looking at a variety of indicators. And we will look at all of them because we have to carry out monetary policy assessment. What is the degree of disruption to our monetary policy transmission channels? That is simply a question we have to answer.
On the first question, as I said before, it really is very much in the hands of governments. They took the initiative a year and a half ago to create the ESM. Now that it is about to enter into force, there are certain limitations that are being brought to the table. There is going to be a political discussion and frankly, it would not be right for the ECB to prejudge the outcome of this discussion, nor to express views on it.

I would like to ask you a question on the supervision of banks: how do you plan to ensure that the two tasks to be performed by the ECB will be separated? In Germany at least, there are still important people who have many concerns about this potential conflict of interest. Jens Weidmann recently raised these concerns in an interview, so what would be your response?

I think there are very important concerns that we are addressing by means of a proper internal organisation. The proposal doesn’t give us much of an option on this. I think one of the principles I stated at the very beginning of this discussion was that, if in the end the ECB is involved in the single supervisory mechanism, we have to make sure we have an organisation which de facto assures the separation of monetary policy from supervision. And this can be done by fully delegating the task to the Supervisory Board. Fortunately, the Commission’s proposal does foresee the possibility of the Governing Council delegating all the supervisory tasks to the Supervisory Board. So, the management and internal organisational means are there. I believe it can be achieved.