“We have reached a contingency where political choices have become predominant over monetary instruments that we can use in the near future" – June 15, European Central Bank (ECB) president Mario Draghi.
Says it all, really. Translation: ECB purchases of sovereign debt could prove the game-changer for the eurozone but, as is now painfully well-known, article 123 of the Treaty on the Functioning of the European Union prohibits monetary financing of sovereigns.
The ECB’s public line is that it merely acts to ensure the monetary transmission channel that delivers price stability remains intact – so large-scale quantitative easing targeted towards specific member states would contravene both the letter and spirit of the EU treaty.
In an interview with Euromoney last month, former ECB executive board member Lorenzo Bini Smaghi held firm, arguing that only sovereigns can rebuild market confidence by embarking on structural reforms and fiscal consolidation. But to his detractors, such hawkish sentiment conjures up the image of a fiddling Emperor Nero during the burning of Rome. In short, the eurozone is stuck in an austerity trap, a strategy of mutually assured destruction.
What’s more, as we have reported, the pressure on Spanish sovereign bond yields highlights the deficiency of the ECB's long-term refinancing operations (LTRO) against the backdrop of unstable collateral values. The LTROs have only exacerbated concerns about the volume and quality of collateral for unsecured lenders, while eurozone banks in stronger economies have parked excess liquidity at the ECB rather than snapping up peripheral government debt.
If the ECB cannot and will not solve the crisis with current policy tools, all market attention is now focused on how euro-area leaders will craft a fiscal and banking union, while further ECB monetary loosening could help, at the margin.
However, in a report released on Thursday, Société Générale believes even if the European Stability Mechanism (ESM) is bestowed a limited banking licence and a boost to its capital, it won’t be enough. In short, debt mutualization – ie German fiscal transfers to the periphery – is the only real game-changer in town. There are four possibilities: (1) European Redemption Fund (ERF), (2) Eurobonds, (3) a broader ECB mandate to be lender of last resort to the sovereigns and/or (4) full banking union.
The path of least resistance is the ERF, the bank reckons, which is a temporary and highly conditional eurozone common Eurobond programme, subject to farcical on-off briefings by Germanic officials in recent weeks.
SocGén says simply: “Our base case is that a European Redemption Fund will come in the medium term; and this would be a game-changer.”
Next up is the prospect of a full banking union.
“The sovereign-bank nexus is a well identified component of the crisis," says SocGen. "Should the euro area adopt a full banking union, complete with common resolution and a full blown deposit guarantee, this would show a strong willingness to share risk at a potentially very high level. In the share of German GDP, deposits in the euro area stand at close to 500%. We do not see this happening in any foreseeable future, but to our minds this would signal a game-changer.”
Here is a pretty menu of choices – like a student perusing a wine list, Germany will probably go for the cheapest option, the ERF.
Most market players believe rising short-term yields on Italian sovereign debt is needed to scare the ECB and Berlin into more aggressive game-changing action. Or as SocGén puts it: "Don’t rule out the possibility of a positive outcome: politics and markets are both fickle, however, and the dramatic interaction between the two can at times lead to surprising outcomes.”
In this context, in the months ahead, expect sticky-plaster options like leveraging the facilities of the ESM/European Financial Stability Facility, despite lacking the financial capacity and efficiency to arrest the decline in the eurozone’s sovereign debt metrics. Or in other words, surely Bunds have to rise further in the months ahead as markets price in greater contingent and actualized liabilities on Berlin’s balance sheet?