Last week, the President of the European Central Bank (ECB) – Mario Draghi, literally lifted global financial markets by unveiling a new ‘unlimited’ bond-buying programme designed to purchase European sovereign bonds in the secondary market. This decision is sequel to Draghi’s earlier pledge to do ‘whatever it takes to preserve the Euro’; this time around, the ECBs plans were well received by financial markets.
A direct result of this plan is that European banks holding sovereign bonds now have a safety net even if these European countries default on their debts. The markets were quick to understand this and within 24 hours, the share price of Spain’s Bankinter SA was up 6%; France’s Societe Generale – 8%; Italy’s UniCredit – 8%; Britain’s Barclays – 6% and even Germany’s Deutsche Bank was up by 7%. While stocks rallied, Spanish 10-year bonds fell to a 3month low of about 5.82%, indicating increased confidence in the strength of the country’s economy. The Euro also closed higher in currency pairings.
If today’s stock prices reflect the present value of future earnings and cashflows, then the above figures are good for the Eurozone and the global economy as well. The ECBs actions should place a downward pressure on interest rates thereby encouraging demand for credit by both retail and industrial clients. This will boost economic activity. Should this plan be successful, the ECB would have shortened the recession and recalibrated Europe for growth. After all, how are countries in the Eurozone expected to meet their debt obligations if they cannot produce?
According to the ECB, the buying of bonds will be sterilized; implying that every Euro spent will be offset by mopping up equal amounts of cash elsewhere within the financial system. In theory, there is no additional liquidity created and the fears of inflationary pressure in the short term seem to be have been allayed. However, there are a few areas of concern. Sterilization in this case means creating new bank reserves i.e requiring European banks to maintain a higher cash reserve balance with the ECB and paying them an interest for these ‘unloaned’ funds. Invariably, banks will be quick to deposit more cash with the ECB at the expense of lending to the real sector – the real engine of growth.
Secondly, the ECB plans to buy only bonds with a maturity period of less than 10 years. This reveals the ECBs plan as a short term tactic rather than the long term strategy which the Eurozone needs to solve the economic problems in the crisis ridden area. Also, the fact that banks are allowed to use the funds tied down with the ECB as collateral when making other risky bets and investments (which could go awry) is worrisome.
That said, Mario Draghi’s silent Bazooka was loud enough to cause ripples as far away as America, where there has been an increased clamour for Fed Chairman – Ben Bernanke to unleash a third round of quantitative easing. Although, the ECB’s plan is not a remedy to Europe’s widespread economic problems, it might just be the strong painkiller that will help restore competitiveness of economies in Southern Europe.