The Final Round?

By Eoin Fahy , Monday, 10th May 2010 | 0 comments

While many 'normal' people spent yesterday watching the final round of soccer's Premier League, rugby's Magners League and golf's Players Championship, financial market participants waited with bated breath for the outcome of what they hoped was another 'final round' of summit meetings in Brussels.  And the outcome was, for once, worth the wait.

In the early hours of the morning, EU leaders finally announced the package of measures they had been working on, and the sheer size and scale of the package was far larger than anyone had expected - which of course was the whole point.  Whatever the EU did, it had be be bigger and more dramatic than the sceptical markets were expecting, if it was going to work.  And big it is!  Eurozone governments will guarantee €440bn of borrowing for the package (if required), to add to a €60bn fund that already existed.  The IMF is set to contribute a further €250bn, taking the total to €750bn (about one trillion US Dollars) in an emergency fund that will be available to help countries that get into difficulties.

Furthermore, and very importantly, the ECB announced shortly afterwards that it would take several measures to help the financial markets:

  • It will buy government bonds and other financial market instruments "to ensure depth and liquidity in those market segments which are dysfunctional".  This is presumably ECB 'code' for bonds of governments that get into trouble, e.g. Greece, Portugal.
  • It will give unlimited amounts of liquidity to European banks, at its fixed 1% official rate, over the next few months.
  • It will make arrangements with the US Federal Reserve to give US Dollar liquidity, as well as euro liquidity, to European banks who need US Dollars but who can't get them from the Fed as they don't operate in the US.

By far the most important measure is the first above (buying government bonds).  The other measures are simply reinstating measures that they ECB had announced in the aftermath of Lehman's collapse.  The ECB is now saying that if a country gets into such difficulties that its bond market is "dysfunctional", it will buy up that country's bonds, presumably in very large amounts.

This is significant for two main reasons.  Firstly, when a central bank decides to buy bonds, it simply "prints" the money to do so.  It doesn't need to borrow the money anywhere else.  So it can be done very quickly, and (in theory) in infinite amounts, as long as it is willing to continue to create money.  Secondly, if the markets know that the ECB is willing to buy bonds if the market is very weak, then they will presumably be far less comfortable to make bets against the country in question in the first place.  In that sense, the ECB may achieve stabilisation without ever needing to buy anything, just by saying that they will do if necessary!

Quid Pro Quo

Of course, the ECB looked for a "quid pro quo" in exchange for this drastic measure, and got in in the form of a promise by Spain and Portugal to announce further austerity measures within the next week or so, and the commitment by ALL eurozone governments to "take all measures needed to meet [their] fiscal targets this year and the years ahead".

Market Reaction

Markets have indeed responded very strongly.  On Friday, the Greek government would have had to pay more than 12% to borrow funds for ten years.  This morning, as of 9.45 am, that cost has fallen to about 7.7%. Portugal can now borrow at 5.1%, down from about 6.5% on Friday, and Ireland's borrowing cost is now about 5.1%, down from 5.9% on Friday.

On the equity markets, most European indices are up between 4% and 7% - a very positive move, obviously, while Asian markets too were encouraged by the news and rose a couple of percent as well.  (Spain is particularly strong, up more than 11% this morning).

The euro has risen sharply on the foreign exchange markets, and now stands at above 1.30 against the US Dollar - a rise of about three cents since Friday, and about six cents since the middle of last week.  Against Sterling, the euro is now worth 87.5p, up about 2 points since Friday.

What's Next?

Analysts and economists have generally reacted well to the announcement.  It doesn't solve all problems, by any means.  Greece, in particular, still faces  a huge debt burden and an eventual default or restructuring of Greek debt is still seen as quite likely.  Furthermore, the ECB's long-term credibility and independence may be damaged by its decision to buy government bonds (though many would argue it would have been damaged much more if it had stood by and done nothing).  And of course nothing in this package will particularly boost economic growth.  But on the whole we do seem to have moved pretty decisively away from the brink of the abyss that was certainly getting uncomfortably close last Friday. 

This won't solve everything, and it's not a magic wand.  But it has removed the  short-term risk of collapse and has to be welcomed.  The very positive market reaction is correct, in our view.

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