Thursday, August 09, 2012

Lack of Commitment by European Central Bank Sends Markets Tumbling

Sources:
Christian Science Monitor: Stocks Slump as Europe Dithers

On August 2, investors sold off European assets following European Central Bank (ECB) President Draghi’s announcement that promised few concrete solutions to the European sovereign debt crisis. This selloff comes only one week after  President Draghi encouraged investors that the European sovereign debt crisis would be contained by announcing the ECB would do “whatever it takes” to save the euro.

In his statement, President Draghi announced the ECB would consider buying bonds of troubled European economies, in particular Spain and Italy, but he did not announce when or how many bonds the ECB would buy. Yields (interest rates) on ten-year Spanish and Italian bonds are currently at 7.13% and 6.3%, respectively. When countries issue bonds, they receive money in exchange for those bonds that can be used to pay off debt. However, when interest rates on these bonds are high, it becomes more expensive for these countries to pay off debt as the countries have to pay back investors more money (in the form of higher interest rates) for the bonds.

Investors hoped that the ECB would announce concrete plans to buy these countries’ bonds in the secondary market—a market where investors who originally bought the bonds from the issuing country sell to other investors. If the ECB bought bonds on this market, it would have the effect of increasing demand for the bonds and raising their prices. When there is an increase in demand for bonds, the interest rate that such bonds pay to investors goes down, which decreases borrowing costs to pay existing debt for countries such as Spain and Italy. Investors fear that if borrowing costs remain high for these countries they may have trouble paying off their debt. The worst case scenario is that these countries default (declare they cannot pay) on their debt, which could potentially lead to widespread selling of the euro as companies and investors seek less risky assets.

Investors were further discouraged by the ECB announcing that before it would enter the bond market, struggling countries would first have to ask for assistance from the ECB and such assistance would come with strict conditions for the countries to abide by. Given the political and economic climate in Spain and Italy, where the unemployment is high and citizens are growing wary of the European Union’s (EU) influence, it is unlikely that leaders in these countries will ask for assistance any time soon. If the conditions, such as austerity measures (reduced spending and increased taxes), attached to bond buying are too strict, political leaders will be reluctant to risk the political backlash that asking for assistance would entail. Moreover, the ECB has stated that the EU’s bailout funds, the European Financial Stability Facility (“EFSF”) and the European Stability Mechanism (“ESM”), must first exercise their power to buy government bonds before the ECB would step in. However, all twenty-seven member-states of the EFSF and ESM would have to approve such an action.

After the ECB’s announcement, yields on Spanish bonds rose over half a percentage point to 7.2% and the Spanish stock market fell 5.16%. The situation was not much better in Italy, as yields on Italian bonds rose by 0.39 percentage points to 6.3% and the Italian stock market fell 4.64%. The euro also fell from a four-week high against the dollar from $1.24 to $1.21 following Draghi’s announcement.

Still, there were some positive messages in Draghi’s announcement. Draghi stated that the ECB would consider ending the requirement that it be a preferred creditor, meaning that it would get paid first in the event of default, on the bonds it buys. Further, the ECB said it would make public which countries’ bonds it has bought, which would have the effect of insuring investors that the ECB would not allow the country default.

Thus, although the ECB has not decided how it would specifically help economies such as Spain and Italy, it has provided a tentative framework. Nonetheless, many investors still believe the ECB should have done more to help ease the debt crisis.

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