After weeks of denying the inevitable, Spain’s leaders have at last finally accepted that they need European assistance to recapitalise their broken banks. How these banks get access to the capital they so desperately require is the subject of much disagreement between Spain and European policy officials. Fearful of the austerity conditions that would be imposed on them if they apply for a bailout to the EFSF, the Spanish government instead is imploring Germany to allow their banks to get funding directly, a position that has some support in both Brussels and Paris. However, neither the EFSF nor the ESM are allowed to make direct capital injections, and Germany remains inextricably opposed to this course in any event. According to Sueddeutsche Zeitung, one option being considered is permitting the EFSF to lend money to Spain’s FROB (the bank rescue fund), under the proviso that problem banks are either closed or merged. This would get around Spain’s fear of signing up to additional austerity and reforms. From the perspective of Germany and the rest of northern Europe, recapitalising Spain’s banks in this way would definitely be much cheaper than a full bailout of Spain, notwithstanding their reservations. Budget Minister Montoro yesterday claimed that the sum required to recapitalise Spain’s banks was relatively modest, at around EUR 40bn. We are not there yet, but it is in both Spain’s and Germany’s interest, not to mention the rest of Europe, to find a way to recapitalise Spain’s banks quickly.
ECB must take the lead. With Europe cratering once more, it would be remarkable if the ECB did not decide to take at least some action when the Governing Council meets today. Growth in the eurozone region has slowed markedly in recent months, and the inflation outlook looks more benign. Council members must also consider how best to respond to the alarming developments in the eurozone’s south, in particular the acceleration in capital outflow. At the same time, the ECB would recognise that there is a limit to what monetary policy can achieve when the major issue is what to do about bank runs and bank solvency. Although their policy options are narrower these days, the ECB must look at measures such as lowering the refi rate (currently 1%), extending full allotment on their refinancing operations, conducting another sizable LTRO (of at least 3 years), widening collateral criteria (it could justifiably be argued that they are generous enough), and continued provision of liquidity through the ELA (Emergency Liquidity Assistance). Some Council members, Mario Draghi among them, want European governments to do more before implementing further measures; although understandable, the fragility of sentiment is such that market participants will not be too happy if the ECB decides to sit on their collective hands.
Fed will be weighing up more QE. Ahead of next week’s G20 meeting and with financial markets in turmoil over Europe’s rapidly worsening sovereign debt and banking crisis, the Federal Reserve will be weighing up very carefully how they should respond. From a macro perspective, both global and local events have moved on significantly since the FOMC last met near the end of April. The international backdrop has worsened markedly, especially in Europe but also in the likes of China and India. Also, the US economy seems to be stuttering, as last Friday’s payrolls data demonstrated. As a result, the expectation expressed at the last meeting that the economy would record moderate growth over coming quarters and then strengthen gradually thereafter now looks dubious. Policy-makers would appreciate that both growth and inflation remain too low, and that financial conditions have the potential to be eased still further. As such, Bernanke and his fellow Board members are probably considering a further round of QE, coupled with an extension of their forward guidance on monetary policy. The next Fed meeting is in two weeks’ time – with global policy-makers under pressure to respond to this latest episode of global economic and financial uncertainty, and with the G20 gathering next week, it is entirely plausible that there will be an announcement before the FOMC meeting.
China is rolling out more stimulus. Unsurprisingly in the context of the recent deterioration in the economy, Beijing is progressively rolling out more stimulus measures in an endeavour to prevent an even sharper slide. Over the last few weeks, policy officials in Beijing have rubber-stamped many large infrastructure projects, as well as announcing increased subsidies and targeted tax cuts. Spending by central government jumped 27% year-on-year in the first four months of 2012. Overnight, the MOF announced subsidies available to households for the purchase of energy-saving domestic appliances. Yesterday, the Xinhua news agency claimed that the government was considering additional policy steps to stimulate investment and trade. Indeed, it would be remarkable if this was not the case – policy officials are presumably working furiously on a package of policies including tax cuts, spending increases, reserve ratio reductions, qualitative monetary easing and possibly even an interest rate cut ahead of the G20 meeting in Mexico next week.
Portugal’s progress on austerity. Although the eco-political narrative in Europe has switched towards an emphasis on growth over recent weeks, Portugal’s progress on austerity and reform is certainly attracting some attention. Indeed, the troika have commended the Portuguese government for their preparedness to stay the course, claiming in their latest review that deficit targets for the country are ‘within reach’. Portuguese Finance Minister Gaspar is a spirited advocate of austerity policies. In a contention that has all of the hallmarks of Germany’s approach to economic policy, Gaspar recently remarked that only through increasing Portugal’s international competitiveness could sustained growth be achieved. Export growth in Portugal has been very respectable over recent months, and state asset sales have been very successful. Portugal’s aim is still to return to the bond market in the second half of next year, although bond yields will need to decline significantly from current levels in order to meet this timetable. Indeed, it is possible that Portugal may require a ‘top-up’ bailout before then over-and-above the existing EUR 78bn programme.