Draghi proposal brings euro grand plan a step closer

AFTER 2? years of incremental crisis management and false starts, a bargain is beginning to emerge between Europe's politicians and central bankers over how to calm bond markets and end the debt tumult threatening the euro's survival.

By InvestSMART · 6 Aug 2012

By InvestSMART ·
6 Aug 2012

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The European Central Bank sketched out its side of the deal last week, offering to buy Italy's and Spain's bonds on the market as long as the euro governments' bailout fund makes purchases directly from the two countries' treasuries and ties them to tough conditions.

The ECB president, Mario Draghi, offered only a glimpse of the new strategy, with actual interventions weeks or months away and a host of obstacles standing in the way before Europe can claim to be on a path out of the crisis that emerged in Greece in late 2009. Investors out for a quicker fix pushed down the euro, European stocks and bonds of at-risk countries.

"All of the announcements, if transferred into actual activity, would be close to the big bazooka approach that the markets are looking for," said Charles Diebel, the head of market strategy at Lloyds Banking Group in London. "Market disappointment is hardly surprising in this context but we may well find this lays the groundwork for the grand plan in coming weeks."

In the trading rooms, sceptics recalled the failure of authorities to deliver on prior crisis-fighting pledges, whether by restricting the use of the original ?440 billion ($516 billion) rescue fund or forcing through a restructuring of Greece's debt after promising not to.

"The big bazooka is Draghi's implied promises, which have not been delivered upon," said Marc Ostwald, a strategist at Monument Securities. "Markets are saying this is all talk, there's nothing concrete."

What is different is that the two countries with their backs against the wall, Italy and Spain, represent 28 per cent of the $US12 trillion ($11.35 trillion) economy and have new leaders that have forced through deficit-slashing measures despite mounting domestic opposition.

"The ECB's decision is important," the French President, Francois Hollande, told reporters in Paris. "It allows the ECB to intervene when it's necessary." The German Chancellor, Angela Merkel, didn't air any immediate qualms last month, she and Mr Hollande made a joint pledge "to do everything to safeguard" the euro.

Europe's political establishment has courted the ECB by giving Mr Draghi a lead role in fixing the birth defects of the monetary union that go back to the 1991 Maastricht Treaty.

Along with the European Union President, Herman Van Rompuy, the European Commission President, Jose Barroso, and the Luxembourg Prime Minister, Jean-Claude Juncker, the central banker is co-drafting proposals for a closer fiscal union and more integrated banking system.

Mr Draghi's pledge took the ECB further away from its roots as a politically autonomous central bank, modelled on Germany's Bundesbank, with prime responsibility for containing inflation and only a lesser focus on the broader economy and the stability of the banking system.

Bloomberg

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Frequently Asked Questions about this Article…

What did Mario Draghi propose to calm euro-area bond markets?

Mario Draghi, president of the European Central Bank (ECB), outlined a plan where the ECB would buy Italian and Spanish bonds on the market — but only if the euro-area bailout fund (the rescue fund) buys bonds directly from those countries' treasuries and ties those purchases to tough conditions. The announcement was a sketch of a strategy rather than an immediate intervention, with actual action described as weeks or months away.

How would ECB bond purchases work under the proposed deal between the ECB and the bailout fund?

Under the proposal, the bailout fund would make direct purchases from Italy’s and Spain’s treasuries under strict conditionality, and the ECB would then buy those countries’ bonds on the open market. The aim is to calm bond markets by coordinating fiscal support (rescue fund) with central-bank market operations (ECB).

Why did markets react with skepticism after Draghi’s announcement?

Markets were skeptical because Draghi’s comments were only an outline and concrete interventions were not immediate. Traders also remembered past failures to deliver on crisis pledges — for example restrictions on the original €440 billion rescue fund and mixed handling of Greece’s debt — leading some strategists to call the talk a promise that might not be fully delivered.

What immediate market moves followed the ECB’s sketch of a plan?

After the announcement, investors seeking a quicker fix pushed down the euro and knocked European stocks and bonds of at-risk countries lower. The article notes market disappointment and increased volatility as immediate reactions.

How important are Italy and Spain in this proposal, and why do they matter to investors?

Italy and Spain are central to the plan — together they represent about 28% of the roughly $12 trillion euro-area economy cited in the article. Because both countries were under heavy debt-market pressure and have new leaders implementing deficit cuts, stabilizing their bond markets is seen as key to calming broader euro-area financial stress.

What do political leaders and EU institutions have to do with the ECB’s proposal?

Political leaders and EU institutions are closely involved. French President François Hollande welcomed the ECB’s ability to intervene, Germany’s chancellor did not publicly object, and Brussels figures — including Herman Van Rompuy, José Barroso and Jean-Claude Juncker — are working with Draghi on proposals for a closer fiscal union and a more integrated banking system. That political backing is part of pushing the plan forward.

Does the proposal change the ECB’s traditional role, and what does that mean for investors?

Yes. The article says Draghi’s pledge moves the ECB away from its traditional, politically autonomous remit focused mainly on inflation (the Bundesbank model) toward a broader role that includes stabilising bond markets and helping to design fiscal and banking union measures. For investors, that signals the ECB may play a larger and more interventionist role in future crises — though the timing and details remain uncertain.

What should investors watch for next as this ‘grand plan’ develops?

Investors should watch for concrete steps rather than rhetoric: specific details of bailout-fund purchases from treasuries, the exact conditionality attached, any timing for ECB market interventions, and political agreement among euro-area leaders. The article emphasises that actual interventions could still be weeks or months away, and markets may remain volatile until measures are implemented.