An ECB leap too late?

Pimco

Global balance sheet deleveraging will play the dominant role in PIMCO's current cyclical economic outlook. Front and centre in this regard is the rapidly progressing sovereign debt crisis in the eurozone, the debt deflationary feedback loop associated with it, and the quality and quantity of policy responses applied to contain it. As goes the eurozone deleveraging, so goes the global economy over the next six to 12 months.

To judge the impact of eurozone deleveraging on the global economy, we must answer three questions. First, how much austerity will the eurozone impose upon itself to restore the balance between debtors and creditors? Second, will eurozone sovereign haircuts or defaults remain a part of the deleveraging process? And third, what role will the European Central Bank play in controlling the depth, breadth and velocity of sovereign debt deleveraging?

Stress testing the plan

Eurozone governments are about to legislate a plan of significant fiscal austerity over the coming years. By PIMCO estimates, austerity programs across both healthy and unhealthy balance sheet countries in the eurozone will pose a drag on growth to the tune of 1.5 to 2 percentage points over the next 12 to 24 months. This means that, absent any increase in private or external sources of aggregate demand, the eurozone economy will likely experience a recession in 2012. Indeed, PIMCO expects the eurozone economy to shrink by 1-1.5 per cent in 2012.

Eurozone sovereign haircuts and defaults will likely remain a part of the deleveraging outlook. The acceleration of the European Stability Mechanism and the introduction of collective action clauses on newly issued sovereign debt under the ESM mean that future haircuts, write-downs and private-sector subordination are still possible – and probable. This, in turn, means that eurozone banks – which have been the chief private-sector financiers of eurozone sovereigns – will need a substantial amount of new capital to maintain their own balance sheets and provide ongoing credit to the real economy for growth. This new capital will be needed primarily to fill the ex ante equity hole generated by now 'risky' sovereign credit exposures. It will also be a necessary condition for maintaining an effective monetary policy transmission mechanism to the eurozone real economy. If eurozone banks remain under-capitalised for much longer, their borrowing costs could climb too high for credit growth, and they would be forced to deleverage private credit commitments at a time when eurozone sovereigns are attempting to do the same with fiscal policy.

To be clear: The eurozone economy cannot bear a concomitant deleveraging in sovereign and banking system balance sheets, given an already weak growth outlook.

The ECB, therefore, must play the critical role of deleveraging police in the year ahead. Only the ECB has a balance sheet large enough, credible enough, and flexible enough to prevent the eurozone sovereign and banking system deleveraging from turning into an uncontrolled Minsky Moment (referencing economist Hyman Minsky and referring to the inflection point when investors must sell assets to pay off debts, pushing down asset prices across the board). An acceleration of the debt deflationary feedback loop will be the odds-on outcome if the ECB continues to play coy with its own balance sheet.

The ECB must, at some juncture in the not-so-distant future, become a lender of last resort to eurozone sovereigns. And, equally important, it must do so with a transparent and credible plan such that private sector demand for eurozone sovereign debt is crowded back in before it is permanently destroyed.

But what will it take for the ECB to make this leap from a bankers' banker to a sovereigns' banker? To begin to answer this question, we have to consider the mandate of the ECB and the game of chicken being played between European fiscal agent and the ECB.

The ECB's evolving mission

First, the ECB has a clear mandate of maintaining price stability and nothing else. In the best traditions of the German Bundesbank, the ECB maintains fierce independence from fiscal policy and financing sovereign deficits and does not believe it is responsible for shaping cyclical real growth outcomes (unlike the US Federal Reserve). A key question, however, is whether the ECB's mandate is symmetrical around low and stable inflation? Will the ECB act aggressively to combat deflation, as it does to combat above-target inflation, when the time comes? And if it will, what tools will it be willing to use, especially if policy rates are already at the zero-bound and the transmission mechanism of policy is broken?

At this point, the rate of inflation in the eurozone is too high for the ECB's liking and is thus likely to prevent the ECB from taking any dramatic steps to pre-emptively combat the forward deflation risks arising from a deteriorating economic outlook across the eurozone.

Second, the ECB is engaged in a dangerous but necessary game of chicken with eurozone fiscal agents, which prevents it from becoming a transparent and credible lender of last resort to eurozone sovereigns. On the one hand, with the credit transmission mechanism broken and bank balance sheets stressed, the ECB recognises that it must prevent sovereign bond prices from falling too far. On the other hand, the ECB remains fearful of introducing secular moral hazard into the process of enhancing fiscal unity and stability across the eurozone by pre-emptively financing fiscal deficits.

This game cannot continue for too much longer. If it does, we believe either the deteriorating economic prospects for the eurozone will accelerate the feedback loop to its Minsky Moment, at which point sovereigns and banks will enter a race to try to out-deleverage the other; or the ECB will take pre-emptive action to become a transparent and credible lender of last resort to sovereigns, thereby stabilising the eurozone banking system and the eurozone economy.

As things stand today, it is more likely that the ECB will leap to a rescue only when it is too late. As a result, the odds of a European Minsky Moment are uncomfortably high.

This was part one of the outlook for the world's biggest economies in 2012, part two – focusing on China and the US – will be published next week.

© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.