Monday, 9 June 2014

ECB goes unconventional: Mr. Draghi is the Super Mario of problem framing

Mario Draghi did it again: negative ECB deposit facility rate (-0.1%); EUR 400bn targeted long-term refinancing operations (TLTRO) for private sector non-mortgage loans; stop sterilisation of government bond purchases done as part of the bank's Securities Markets Programme (SMP); potential future acquisition of non-financial private sector asset-backed securities (ABS). The announcement that more unconventional measures are likely to come "Are we finished? The answer is no, we aren't finished here. If need be, within our mandate, we aren't finished here" (Draghi dixit)

(For more details click here)

The official version is that these measures are directed at fighting the risk of deflation in the Eurozone. Is that really all that is being targeted? Is that really all that could even be targeted even if the sole goal were to fight the risk of deflation?

Let's put things in perspective: with the potential exception of the ABS bit, none of the announced measures will be effective in fighting deflation without a healthy and properly working banking system able to act as a transmission mechanism of ECB's (unconventional) monetary policy. However, currently the Eurozone's banking system is to a large extend under-capitalised. And therefore unable to act as "the" transmission mechanism. No matter how unconventional ECB's policy measures may be.

A proper recapitalisation of the system will take time to be fully achieved and to be done smoothly requires supportive equity markets:

- The results of the Asset Quality Review (AQR) exercise currently under way will be released in November 2014. Eurozone banks with capital shortfalls will then have 6 to 9 months to recapitalise themselves, i.e., till May to August 2015.

- Recaps should be mainly done via capital increases in the market place

- But private investors will only provide the financing if equity market's are booming and the sentiment is positive

Mario Draghi is surely aware of this. And therefore knows that it has to do "whatever it takes" to support the currently positive momentum in financial markets in general and equity markets in particular. This is what the measures announced last Thursday (5 June) have ultimately to achieve to be successful in fighting deflation.

In addition, it is not really desirable that financial markets start to collapse shortly after the Eurozone bank recaps are concluded. Banks would have to start to write off some of their then overvalued assets again and we would be back to square one. On top of it, the Bank Recovery and Resolution Directive (BRRD) with full bail-in mechanism - potentially going beyond equity and subordinated debt - will enter into force in January 2016. Not really a good time to see the markets roll over.

Putting all this bits and pieces together gives us a broader picture of what is going on, with the risk of deflation occupying just a corner area of the whole picture. And the conclusion can only be that Mario Draghi will keep doing whatever it takes to keep investors in Eurozone's financial markets happy and cheerful until way into 2016.

Given that deflation in at least the non-tradable sectors is set to remain in place in the Eurozone periphery, following the adjustment in local nominal salaries (never mind that this will actually increase consumers purchasing power and lead to a rebound in consumption rather than a deferral of it in these countries), inflation is to remain very low in the whole of the Euro area over the entire period. Mr. Draghi can therefore continue to frame the problem he is facing as one of pure deflation. It is academically elegant, politically convenient and easier to be accepted by Bundesbank hawks. And thus able to gain unanimous support for additional unconventional policy measures. Nothing really new here: support for an action is more readily won by a skilful and attractive framing of the problem at stake than of the action intended to solve it.

Will ECB's interventionism create distortions in financial markets? It surely will. Misallocation of capital? No doubt. An adverse impact on long-term productivity and economic growth? Most likely. Will the boom eventually end in a bust? Yes - gravity in economics as in finance does exist.

Should you fight Mario Draghi now? No. Over the next 18 to 24 months Mario Draghi will be Super Mario. And you should never fight a super-hero at the top of his game. Just enjoy his skill and make the best of it.

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