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Sunday, 17 December 2017

The magician’s finest hour

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  • The magician’s finest hour

Mario Draghi pulled yet another rabbit out of the hat, surprising investors on the upside by launching a scaled-up quantitative easing programme on January 22, with the ECB set to buy €1.1trn worth of bonds between now and September 2016. Well received by markets, the eurozone’s iteration of QE aims to tackle deflation for good and bring back jobs and growth to the eurozone. He has also left the door open to a far more permanent QE if inflation doesn’t come surging back soon, echoing the multi-stage QE programmes favoured by the Federal Reserve.

Is there a more impressive magician out there than Mario Draghi? Yet again the master of sleight of hand and the well-turned phrase pulled off a trick few were expecting. By announcing the roll-out of a €1.1trn (US$1.25trn) QE programme on January 22, the president of the European Central Bank was merely fulfilling a long-standing promise: to buy the issued bonds of eurozone governments, thereby injecting growth and inflation into the ailing 19-member monetary union.

Yet despite having signalled his intentions months in advance, Draghi still managed to surprise. Partly that was because some half-expected QE to be held in abeyance until March, allowing the Frankfurt-based institution to weigh up the implications of a looming election win on January 25 by the Greek leftist party Syriza.

Others were heartened by the scale of the programme, which will see the ECB inject €60bn in new money into financial markets every month until at least September 2016 (most experts expected QE to come in around the €50bn a month level), buying debt with tenors ranging from two to 30 years. IMF managing director Christine Lagarde was not alone in tipping QE to “lower borrowing costs across the euro area, raise inflation expectations and reduce the risk of a protracted period of low inflation”.

Benjamin Moulle, head of SSA syndicate at Credit Agricole, said Draghi “really caught the market by surprise with a larger-than-expected” plan that left “everyone in no doubt that they were serious about making QE work”.

Philippe Rakotovao, global head of Credit Agricole’s corporate and investor client division, said the ECB’s reaction to the Greek election had been “impressive”, adding: “Draghi has created a fantastic shield that protects the market from any external or internal shock that could hurt the market. There was a real and immediate test in the form of the Greek election and it worked.”

Markets reacted immediately, the euro slipping to an 11-year low against the US dollar. “Within a few hours of the QE announcement, it had already significantly changed the yield and spread level,” said Pierre Blandin, head of DCM, SSA, at Credit Agricole.

Said Marco Baldini, head of corporate and SSA syndicate at Barclays: “[T]here is now a credible chance that this asset purchase programme may make a real difference to the eurozone recovery. They had not a lot of room to surprise and a lot of room to disappoint and so far they seem to have pulled it off.”

European stocks surged while yields on peripheral European sovereign debt tumbled, with 10-year Spanish bonds falling to a record low of 1.25% and Italian yields hitting 1.41%, while analysts rushed to divine the macroeconomic impact of financial stimulus. In a note issued the next day, Philippe Gudin, chief European economist at Barclays, said a depreciation of 10% in the euro could add 0.5 percentage points to regional growth in both 2015 and 2016.

This may come to be Mario Draghi’s finest hour. His vow to do “whatever it takes” to support the euro in July 2012 eased borrowing costs in peripheral states and helped preserve the single currency. Those words raised hopes of a pan-eurozone QE programme in the mould of those rolled out in the US and Britain, though hopes were quashed by the Bundesbank’s inbuilt fear of inflation. Yet as 2014 wore on, with Europe’s largest economy flirting with recession and deflation beginning to bite, it became clear that some form of financial stimulus, however unpopular in Berlin and Frankfurt, was better than none at all.

Even then, the programme still had to be sold to key power brokers. As ever, Draghi’s success lay in his quiet mastery of detail and politics, and the ability to walk his own line. In a brief speech last August in Wyoming, the ECB chief deftly presented the case for QE, catching the central bank community off-guard.

Draghi then courted the German media to explain why QE was preferable to permanent economic torpor, even for an economy with a large savings surplus. After the European Court of Justice gave the nod to stimulus on January 14, he sat with German chancellor Angela Merkel to assure her that QE would ring-fence the risks associated with government debt purchases, and prevent German taxpayers from having to mop up losses occurring elsewhere in the eurozone.

QE’s simple message…

Underlying it all, said Christian Schulz, senior economist at Berenberg Bank in London, lay a very simple message: that quantitative easing was essential for a flailing economic community desperate “to return to both growth and a normal inflationary economic environment, while cutting unemployment”.

Draghi also cunningly courted investors by leaving the merest whiff of an open-ended stimulus lingering in the air. By linking the success of the QE programme to the immediate need to return price inflation to the region, he left the door open to future rounds of stimulus.

The ECB chief was careful not to bind himself to specific inflation targets or expectations: rather, he articulated the importance of keeping stimulus in place until “we see a sustained adjustment in the path of inflation” consistent with keeping inflation around the official target of 2%. If inflation returns to that level before September 2016, Draghi can scrap or pare back QE; if prices remain low, he can extend the programme indefinitely.

That uncertainty (a rare case of ambiguity being welcomed by the investment community) helps explain the market’s hearty approval of Draghi’s plan. “The main question going forward is whether the ECB will need to act like the Fed, which had several tranches of QE over a three, four-year period,” said Credit Agricole’s Rakotovao.

Bankers said Draghi again appeared willing to do to whatever it takes to secure a permanent return to inflation and growth. “If there is a need to inflate the balance sheet of the ECB above the €1.1trn level, I have no doubt they will do it,” said a London based DCM banker.

So far so good, then, with European QE, which will see the ECB’s monthly repurchases split between €50bn worth of government bonds and €10bn worth of debt issued by agencies and supranationals, along with a healthy sprinkling of covered bonds and asset-backed securities. The central bank has also been careful to limit its exposure to any single sovereign to 25% of each issuance.

Lee Cumbes, head of SSA origination, EMEA, at Barclays, was correct when he said that the ECB had “consistently over-delivered on almost every measure”. Bankers and investors said Draghi played a poor hand with great good sense, convincing investors to buy in, and eliciting the benefit of the doubt from the Bundesbank’s sceptics-in-chief.

“There is a credible chance that [QE] may” speed up the region’s economic recovery, said Barclays’ Baldini.

… yet the fire burns ‘brightly, but quickly’

Yet financial stimulus will only achieve so much. Many see it as a palliative rather than a cure. Euro-denominated debt issuance by sovereigns, supranationals and agencies “won’t change dramatically as a result of QE”, said Credit Agricole’s Blandin – nor will it by itself bring jobs and growth back to the region.

Some fear that even Draghi’s enlarged programme is too modest. The Bank of England’s £25bn a month bond repurchase programme, launched in 2009, was the equivalent of 20% of UK GDP. Europe’s iteration is worth just 7% of eurozone output. Others fear it’s too little too late: that the eurozone’s woes have become too deeply embedded, too chronic, adequately to solve.

Moreover, QE does not address the major structural flaws that course through the eurozone’s economy. Draghi & Co “know that the region needs more sovereign reform, more corporate reform, more banking reform, more social and cultural reform, and pension reform – and that QE won’t really achieve anything”, said Marcus Svedberg, chief economist at emerging-market investment manager East Capital.

QE’s fires are likely to burn “brightly but quickly”, said Enrique Febrer-Bowen, head of ECM financial institutions, EMEA and Iberia, at Barclays. “Unless you get proper labour reform in place across the eurozone’s periphery, QE cannot cure what ails the region. And given that interest rates remain at historic lows, with banks struggling to drive net interest margins, I foresee very little growth in the eurozone as a whole.”

One factor far removed from any action taken in Brussels, Berlin or Frankfurt may still, however, come to the eurozone’s rescue. Sharply lower crude prices have slashed the price of everything from food to transport to textiles. That’s bad for short-term inflation but good for European politicians desperate to get consumers spending again.

“All EU nations are net importers of oil, and this could create more growth than we had previously anticipated,” said East Capital’s Svedberg. Add lower oil prices to QE and you might – just might – have all the ingredients you need to conjure up a full-blown European recovery. But then maybe that was magical Mario’s intention all along.

To see the digital version of this report, please click here.

To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.

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