This will be my last morning note for a few days — I will be on holiday in Abu Dhabi next week.  


All the exciting news of the past 24 hours has been about the monetary and fiscal developments in Europe. I will start with the monetary side. The ECB cut interest rates by 25bps in a majority decision (yes, there are people on the ECB board who think that the present situation does not call for a rate cut). At his press conference, Mario Draghi announced four further measures to help the Eurozone banking system:
  1. Two 36-month LTRO’s with the option of early repayment after one year. These will replace scheduled 12-month LTRO’s.
  2. The rating threshold for certain ABS will be lowered, in an attempt to reduce the collateral crunch. A second-best rating of A will be required (AAA previously). ABS that have residential mortgages or business loans as their underlying will be eligible.
  3. Reserve requirement ratio will be reduced from 2% to 1% to free up collateral. 
  4. Certain technical month-end fine-tuning operations will be discontinued.
Draghi also made it pretty clear that markets had misinterpreted his comments about “other elements” following from a fiscal agreement in the Eurozone — as I said in my note yesterday. Markets took them to mean that the ECB might step into the sovereign bond markets in a bigger way. Draghi poured cold water on that idea, saying that the spirit of the EU treaties had to be respected regardless of whether any legal tricks could be found to circumvent the ban on ECB financing of national governments. He was very clear on this subject. Of course, a U-turn is always possible (and, in extremis, likely) but it would entail a significant loss of credibility for Draghi after yesterday’s performance. This means that one solution to Europe’s problems is probably off the table for now.

What was Draghi talking about when he use the “other elements” language? It seems that he has in mind a “fiscal compact” with three components:
  1. National economic policy: fiscal sustainability, pro-growth policies and, consequently, job creation.
  2. EU-level rules on fiscal policy.
  3. A stabilisation mechanism — Draghi’s preference being the EFSF and ESM.
It seems that he meant that once 2. was in place, 1. and 3. could follow — so he was doing political analysis.

Will the measures announced help the banking system? I tend to think that the answer is “yes, at the margin”. Unlimited 36-month lending is more stimulative than unlimited 12-month lending plus a demonstrated willingness to take such a step if necessary — but I cannot see that it is that much more stimulative. I have not seen any analysis on how much more collateral will become available as a result of the further relaxation of collateral standards (the ECB already has the loosest standards in the developed world). Draghi said that the move was mainly a measure to help smaller banks (which account for the bulk of SME lending). I have not done or seen any analysis of the effect of the reserve requirement loosening. I need to look further into all these questions in the coming days.

Let us move on to the fiscal side. After the first day of the latest European summit, it appears that the following measures have been agreed:
  1. The ESM will be brought forward from July 2013 to July 2012. Its EUR 500m lending cap will be reassessed by March. With the monetary solution off the table, Europe requires a fiscal solution — transfers from the periphery to the core — and with this change, European leaders have said that they will think about creating a vehicle that is big enough to deal with whatever transfers prove necessary. That is hardly a breakthrough, although it is better than not thinking about it or messing around with leverage schemes in an attempt to shirk their responsibilities.
  2. Countries, on an individual basis, will make an extra EUR 200m available to the IMF. This is accompanied by the usual chatter about some white knight from the developing world riding to the rescue. 
  3. The 17 Eurozone countries will move further towards fiscal union with a new intergovernmental treaty that commits its signatories to fiscal rectitude. Most other EU members will intend to join this treaty at some point; Britain will not. The phrase “shutting the stable door after the horse has bolted” springs to mind, but an indefinite commitment to Germanic fiscal prudence is probably a precondition for the fiscal transfers through the IMF/EFSF/ESM. It seems almost churlish to point out that Germany was one of the worst miscreants when it came to breaching the old Stability and Growth Pact, Spain had low debt/GDP before the crisis and Ireland’s budget was in surplus. Still, the Europeans have decided that fiscal malfeasance was the cause of the crisis. I try to avoid cynical conclusions, but it does seem to me that they are being awfully stupid in this regard.
Overall, the outcome of all the noise of the past few days is: no decisive ECB action; no increase in fiscal transfers to the periphery; and a treaty that commits Eurozone governments to the kind of austerity programmes they were doing anyway. I cannot see that any of this makes any real difference, although the IMF lending and hints of an expansion of the ESM show that Europe is groping towards a solution based on fiscal transfers. I expect its painfully slow progress to continue — though painful it will be, with the ratification process for a new treaty now added to the mix — and the ECB to buy peripheral bonds as necessary to prevent a meltdown in the meantime (but not so much as to take the pressure off national governments). As I said on 13th August: “The pattern I expect to see in the future is the same as the playbook for the current episode: poor economic performance raises PIIGS spreads again; politicians agree to expand the powers or capital of the EFSF [now read EFSF/ESM/EU-funded IMF] to deal with the problem; and once agreement is reached, the ECB buys sovereign bonds to prevent a self-fulfilling crisis in the short term.”

Britain is apparently “isolated” in Europe after refusing to sign up for full-blown treaty change that would have seen us hamstrung by various daft EU measures like a Tobin tax. This is the British media’s usual schoolyard-level analysis of the European situation. It is as if a bunch of cool kids have decided to do something silly and dangerous. If Britain refuses to join in, it is portrayed as the awkward child whom nobody likes; if it goes along, it is portrayed as the weak child who foolishly follows the crowd. The solution to this national neurosis is to grow up. Britain is a member of the EU and therefore part of the crowd. Our interests are as legitimate as those of any other member, and it is quite reasonable for us to protect them. They way to do that is to refuse to accept action on a European level when our vital interests are threatened. This is what other EU countries do, and have done at least since the French “empty chair” crisis of 1965. Countries that fall for the “community” rhetoric and fail to fight for their national interests tend to find them compromised.

Further, it is not just Britain that is wary of the latest round of EU measures. The FT reports that the Finnish parliament prevented the government from agreeing changes to the treaty that sets up the ESM; that pro-European parties in the Netherlands have threatened to force a referendum if there is treaty change; that the EU has become a major issue in the Slovakian election; that Ireland may have to have a referendum on any treaty change; and that even in Germany, the FDP is considering blocking the ESM. None of this bodes well for the smooth negotiation and ratification of a new treaty. Expect the market to be thoroughly confused.

Data:

Bank of England held rates and asset purchase facility size.
ECB cut 25 bps.
Inital claims 381k b.e. This is the lowest level since Q1 2011, and before that since 2008.
Wholesale inventories jumped 1.6%, a bad sign, in October.
Japan final GDP 1.4% QOQ. Revised down on negative corporate investment. Q3.
China CPI 4.2% Nov., lower than expected and down from 5.5%p. PPI 2.7%, also lower than expected. Chatter about monetary loosening abounds.
China fixed asset investment 24.5% YTD/Y, d.e. Nov.
China IP 12.4% YOY d.e. Nov.
China retail sales 17.3% YOY b.e. Nov.
German trade surplus fell, disappointing expectations, but remains wide.
French IP 0% b.e. Oct.
UK PPI 0.1% d.e. Nov.
UK trade deficit was narrower than expected, but remains quite wide.

Next 24 Hours:

US trade balance
Preliminary Michigan sentiment
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