By Luke Iott for Global Risk Insights
As Lithuania joins the euro and Greek elections loom, decisions are critical for the Eurozone as all eyes shift to the ECB. The central bank has been waiting to take any definitive action to curb low inflation in the Eurozone, hoping that the latest economic data would be positive.
However, with the sharp drop in oil prices providing additional deflationary pressure on the already fragile block, it comes as little surprise that January data showed headline inflation had dropped by 0.2 percent, officially dragging the Eurozone into deflationary territory and fuelling expectations that the ECB will take action to unleash a quantitative easing-type program similar to what we have seen in the United States, United Kingdom, and Japan.
Up until now the ECB and its president, Mario Draghi, have been able to bolster European markets by hinting at a possible ECB intervention. His July 2012 promise that the ECB would “do whatever it takes” managed to lift markets temporarily, as did the creation of the Outright Monetary Transactions (OMT) program, in which the ECB proposed (but never carried out) purchases in secondary sovereign bond markets.
In his latest statements Draghi has continued to rely on strong ECB rhetoric to keep markets afloat, first saying that the ECB “intends” and then “expects” to increase the ECB’s balance sheet by 1 trillion euros. Yet, at the risk of crying wolf one time too many and with January data adding more fears of Japanese-style deflation coming to the Eurozone, pressure is firmly placed on the ECB to offer more than words at its next meeting on January 22nd.
With the end of the month approaching, policy makers are weighing options to purchase 500 billion euros worth of sovereign bonds in order to boost the bank’s balance sheet back up to 3 trillion euros.
Continued German opposition
Unfortunately, however, economic data is not the only indicator that will inform an upcoming decision by the ECB. As the hesitation surrounding any QE action has been largely political, two events in January are likely to shape ECB policy moving forward and could hinder any action in January.
The first is the preliminary ruling by the European Court of Justice on January 14th surrounding the legality of Draghi’s OMT program. Brought forth by the German Constitutional Court, the program’s opponents have argued that OMT goes beyond the ECB’s mandate and works against treaty rules which prohibits the bank from financing individual governments.
While not binding, the ruling will most certainly reflect the court’s final decision, scheduled for May. Any negative ruling by the court would hinder the ECB’s ability to purchase sovereign bonds and strongly shape any possible ECB action moving forward at all.
However, while the German Constitutional Court ruling earlier this year in February led many to declare OMT “effectively dead,” markets have ignored the decision, with sovereign risk premiums continuing to decline, providing confidence that OMT will be carried out.
The German Constitutional Court’s referral to the ECJ in the first place has also been an indicator that a positive ruling is likely. Many see this as a way for the German Court to tacitly consent to a positive ECJ ruling while washing its hands of a final decision, which would prove divisive considering the strong political opposition in Germany to OMT and sovereign bond purchases.
A likely outcome will be an ECJ ruling on OMT that would allow the bank to move ahead with any easing program, but that would also impose additional conditions such as limiting the amount of government bonds the ECB can purchase.
Greek elections could postpone an ECB decision
The second, is that the ECB has come up against a possible political confrontation in Greece, where elections scheduled for January 25th are expected to bring Syriza to power. The leftist party has risen to popularity on promises to end austerity and renegotiate its bailout conditions.
Greek elections three days after the January ECB meeting make the timing of any bond-purchasing announcement extremely difficult, especially considering Greek demands for debt restructuring. ECB Governing Council member Ardo Hansson has already noted that “announcing a bond-buying program including Greek government bonds in January (to be) problematic.”
Traditionally, the ECB has also avoided making decisions ahead of national elections in an attempt to remain independent of politics. A decision so close to Greek elections could be seen as interference in the democratic process and increases the chances that any announcement concerning QE is delayed until the bank’s next meeting in March.
What action could the ECB take?
Despite the clear political obstacles to a QE announcement this January, the ECB has released some information about how a potential QE program could be structured moving forward which would soothe both German concerns and avoid complications with Greek elections.
In the first case the ECB would buy government bonds in a quantity proportionate to the member state’s share of holdings in the ECB. In this case, there would be a more equal division of risk.
However, this would also mean that bonds from peripheral states, who are most in need of help, would be bought in the lowest volumes while French and German bonds, whose yields are already low, would make up the largest portion of purchases.
A second possible scenario would be similar to the first, but national central banks, not the ECB, would buy government bonds. While this would prevent any questions concerning mutualization of debt and risk, it would also send a negative message to markets about the unity of the Eurozone as a monetary union.
A third tactic discussed by officials is for the ECB to only buy AAA-rated government bonds with the aim of pushing investors to buy riskier sovereign debt themselves.
This would effectively avoid any problems with Greece, whose bonds are not investment-grade, and would allow the ECB to make an announcement in January despite Greek elections shortly after.
QE still uncertain in January
Since Draghi’s statement late last year that the ECB “expects” to increase its balance sheet, the question surrounding QE has not been “will it happen” but when and how. With Eurozone inflation sliding further downward, ECB rhetoric is running cheap and markets are expecting action. Yet, the when and how remains uncertain.
Despite continued debate and increasing consensus that ECB intervention is needed, any action will depend heavily on political developments leading up to the bank’s meeting at the end of the month.
Investors must keep a close eye on both the ECJ’s proceedings and the run up to the Greek election, both of which will inform ECB policy moving forward.