August 14, 2012
While markets have been cheered by recent ECB announcements on sovereign debt, some still question the Bank’s ability to save the euro. This column argues that the ECB is a lot stronger than many think. Linking ECB sovereign bond purchases to policy conditionality will ensure that reform efforts are sustained. The free lunch option has been ruled out – and that is a good thing.
Disappointment in the financial markets at Draghi’s latest press conference was predictable, understandable – and misguided. You could measure it by the movement in the euro-dollar rate, with a hopeful spike quickly followed by a despondent plunge as the press conference unfolded.
Draghi’s main messages can be summarised as follows:
- Exceptionally high risk premia on sovereign bonds, driven by fear of a euro break-up, are unacceptable and must be reversed, especially as they lead to an increasing fragmentation of the Eurozone financial markets.
- For risk premia to be compressed in a sustainable manner, governments need to make further progress on fiscal and structural reforms, to eliminate the underlying fundamental imbalances: divergences in competitiveness, in current-account balances, in fiscal trends.
- As financial markets are behind the curve in recognising progress on structural reforms, policymakers have to be ready to step in with bond purchases by the EFSF/ESM rescue funds, and possibly ECB bond purchases.
- To benefit from ECB bond buying, however, governments must accept conditionality, requesting EFSF support and signing a ‘memorandum of understanding’.