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ECB's Dilemma

The eurozone’s monetary woes never end. They mutate as the economic cycle matures, just as intractable in good times as in recession. Today’s bubbly recovery – engineered in the nick of time to avert a eurosceptic dégringolade in the French elections – already contains the seed of the next crisis.

It brings forward the day when the European Central Bank runs out of plausible justifications for why it is covering Italy’s entire budget deficit and rolling over its existing €2.2trillion (£1.9 trillion) public debt.

This long-feared moment of ECB tapering could be painful, both for Italy and for bond-holders. “There are risks that euro area bond yields could increase abruptly without a simultaneous improvement in growth prospects,” said the ECB in its Financial Stability Review released yesterday.

That would lead to a return of the Sisyphean “denominator effect”: nominal GDP would not expand fast enough to keep pace with the rising cost of debt service for the vulnerable states. The ECB specifically warns of a “snowball effect” in Italy and Portugal.

There has been scant improvement in the underlying debt dynamics of the Club Med bloc. Quantitative easing has helped. It has bought time to lengthen the maturity of the debt stock. More than anything it has papered over insolvency.

The report says that ultra-low rates compress deficits and flatter fiscal profiles. “This masks the fragility of public finances in some countries,” it said. Several are on “a clearly unsustainable path” under current fiscal policies. All it will take is a shock.

The problem – as always in Europe – is political, compounded by the infernal task of trying to bridge the North-South divide with a one-sizefits-all
monetary policy.

German economists think that their economy is close to overheating. Berenberg Bank says the IFO measure of business confidence has reached the highest since the start of pan-German statistics in January 1991.

It even tops the peak of the reunification boom, which ended in an inflationary blow-off. This is staggering. It is why Chancellor Angela Merkel fired off her warning shot this week, grumbling that “the euro is too low because of ECB policies”.

Her rebuke was nothing compared with the anathemas thrown at Mario Draghi in the Dutch Tweede Kamer, where hard-money MPs accused him of destroying the Dutch pension industry in a stealth policy really aimed at bailing out Italy.

Lakshman Achuthan, from the Economic Cycle Research Institute (ECRI), says his “future inflation gauge” for Germany has spiked to a 35-year high. The ECRI model is used to anticipate turning points. What it shows is that powerful pressures are building up. “It can’t be dismissed as transitory noise,” he said.

By some estimates, German GDP is currently growing at an annual rate of near 5pc. The country’s orthodox professors are up in arms. “The ECB cannot shrug off the changed circumstances in the economy. It must end its bond purchases,” said Clemens Fuest, head of the IFO Institute. He says ultra-loose policies are distorting the capital markets, hurting banks and insurance companies, and bleeding savers to help debtors. QE is near its technical limits anyway. The ECB balance sheet has reached €4.17 trillion, or 39pc of eurozone GDP. The US Federal Reserve never went so far.

Personally, I sympathise with Mr Draghi’s view that the eurozone is not yet safely out of the deflation trap. Core inflation has barely moved. Japan’s long ordeal – or indeed the ECB’s rate rise blunder in 2011 – suggest that it is more dangerous to tighten too early than to slip behind the curve. But that is not the view in Germany.

With “Frexit” risk out of the way, a taper bargain is emerging. The ECB will first toughen its “forward guidance” in early June. Francesco Papadia, the ECB’s ex-head of market operations, said it will signal the end of QE in September, and start to taper its €60bn monthly purchases after new year. Interest rates will rise from minus 0.4pc in mid-2018. That at least is the plan.

The markets know this. Trouble will begin earlier, especially if the Italian elections are pulled forward to September 24 after a deal on electoral reform between Matteo Renzi’s Democrats (PD) and Forza Italia.

Mr Papadia says this will not lead to “Italexit” and a return to the lira. Coercive steps will be take to stop this happening if need be. “Perhaps the Troika will arrive,” he said with refreshing candour.

Yet the taper will come, and Bundesbank chief Jens Weidmann will be there to make sure that the ECB’s Governing Council sticks to treaty law. “We can’t put off monetary tightening for the sake of public finances in certain countries or because of potential losses by investors. The ECB must show backbone,” he said.

Italy is in the firing line. Marchel Alexandrovich, from Jefferies, said that QE enabled Rome to raise money at an average rate of 0.55pc last year. It has cut debt service costs to 4pc of GDP from 5.2pc in 2012. But this could go into slow reverse. “If the ECB mishandles tapering and market rates rise too fast, austerity is back on agenda,” he said.

Mediobanca told clients in January that the chief effect of ECB bond purchases in Italy has been to finance €220bn of capital flight, mostly into funds in Frankfurt and Luxembourg.

It let investors exit at a profit – as in Greece – and switched the liability to the Italian state. The Bank of Italy now owes peers in the ECB’s Target2 payments system €420bn, more than 25pc of GDP.

The country is left naked once the ECB rips away the shield. The shock will be made worse by new rules on tangible equity that force Italian banks to slash holdings of government bonds by €150bn. “Tapering will leave Italy without the key buyer of its debt,” it said.

Mediobanca said the Italian treasury will face an “ownership problem” on €1 trillion of debt coming due over the next five years, and markets will do their sums long before. “Our conclusion is that a voluntary debt re-profiling, an Italexit scenario, or a combination will inevitably gain traction with investors,” it said.

What cannot be avoided is the logic of a public debt ratcheting above 133pc of GDP in an economy that has languished in depression for much of the last 18 years, with a fall in per capita income fall of 2pc since the turn of the century.

Enjoy the Goldilocks moment for the eurozone this spring. It has the life-expectancy of a Monarch butterfly.


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