Euro area economic activity appears to be bottoming out

ECB economic assessment not markedly changed but Mr Draghi chooses to focus on downside risks.

• Mr Draghi seeks to ease concerns about firmer money market rates and stronger euro but hints that offsetting action will be taken if needed.

• ECB says it didn’t take any decision on Ireland today. While technically correct, it is clear that a relatively favourable deal has been agreed.

• Outlook for Irish growth and return to market finances improved.

If we look at it from a broad European or market perspective (rather than that of Ireland), today’s ECB press conference should have been a relatively dull affair. The ECB will be happy that recent survey data seem to confirm that euro area economic activity appears to be bottoming out, that inflation has fallen to its lowest level in over two years and Eurozone money markets continue to ‘thaw’ as risk sentiment improves. Admittedly, we remain some considerable distance from the point where conditions in the ‘real’ economy or financial markets could be described as having completely ‘normalised’ but there is a widespread recognition that any recovery process will be an extended one. For these reasons, there was little expectation of any significant policy initiative today—ECB policy rates were as expected left unchanged and Mr Draghi might have hoped to do little other than present a cautiously positive assessment of work in progress.

In a low key but frequently awkward press conference today, Mr Draghi spent most of his time trying to deflect repeated questions about what looks to be a significant change to the funding mechanism for that portion of Ireland’s banking debt that relates to the Irish Banking Resolution Corporation (the wind down vehicle for the former Anglo Irish Bank and Irish Nationwide Building Society). The significance of this development means we discuss it at some length below but Mr Draghi also made a number of other important comments in relation to the ECB’s current policy stance that merit attention.

In very broad terms, the ECB’s assessment of current economic conditions in the Euro area hasn’t changed markedly in the past month. The ECB now feels weakness ‘is likely to prevail in the early part of 2013’ a slightly less negative phrasing than a month ago. The ECB thinks that the various actions it has taken ‘will in the end find their way through the economy’. As a result, Mr Draghi ‘foresees a gradual recovery in the second half of the year’.

The expectation that the euro area will improve as 2013 progresses means the ECB doesn’t envisage cutting interest rates further at this point but the door is not firmly shut on further easing if circumstances deteriorate. A key element of Mr Draghi’s presentation today was an emphasis on the ECB’s determination to maintain an accommodative stance. This stems from an appreciation of the still fragile condition of the Euro area economy and the fact that the ECB continues to see risks around the economic outlook weighted to the downside. More importantly, Mr Draghi’s comments today seem to suggest some emerging concerns that recent signs of stabilisation in economic conditions could be threatened if either a firming in money market rates or the strengthening in the exchange rate of the Euro of late were to go much further.

In recent weeks, money market rates have firmed as commercial banks made an early repayment of some €140.6 bio of the €489.2 bio that they had drawn down in the first three year refinancing operation implemented in December 2011. The ECB signalled today a strong desire that any impact on liquidity conditions from these repayments should be contained and would not be allowed to develop to the point where a tightening in financial conditions was threatened. By noting ‘we will closely monitor conditions in the money market and their potential impact on the stance of monetary policy, which will remain accommodative with the full allotment mode of liquidity provision’, the ECB set out its position very clearly. While it clearly welcomes the emerging improvement in money market conditions, the ECB seems prepared to take a very ‘activist’ approach to ensure that early LTRO repayments don’t prompt notably firmer money market rates.

In isolation, the recent firming in shorter dated money market rates might attract only limited attention but it has also contributed to a strengthening of the euro on FX markets. Mr Draghi was careful not to suggest the ECB is overly concerned at present. He said the rise in the euro was a sign of external confidence in the euro area and current levels of the exchange rate were broadly in line with long term averages. Importantly, he also said that if upward pressures become significant, the ECB will alter its risk assessment when it publishes new economic projections next month. This is a veiled hint that the ECB might be willing to consider action, possibly even extending to a cut in its refinancing rate, if exchange rate movements and other developments suggest a notably weaker trajectory for inflation and growth in the next year or so than is currently envisaged.

We would interpret Mr Draghi’s comments today as relatively dovish. The ECB recognises any turnaround in economic or financial conditions could easily be reversed and as such emphasised its commitment to ensure policy remains accommodative. If financial conditions were to tighten materially either through a further firming in money market rates or a significant rise in the euro’s exchange rate, Mr Draghi hinted today that the ECB would contemplate offsetting action either through liquidity measures or possibly even through easier policy. At very least Mr Draghi is engaging in verbal intervention to stem unwanted movements in money market rates and the euro.

Ireland Debt Deal Dominates Proceedings

Although Mr Draghi tried hard to avoid the issue, there is little doubt that significant changes in the funding mechanism for that part of Ireland’s banking debt that is related to the former Anglo Irish Bank and Irish Nationwide dominated proceedings today in Frankfurt. While Mr Draghi was technically correct to say that the ECB didn’t have a decision to take today in regard to this matter, the reality is that the more detailed announcements made today in Dublin represent the outcome of a prolonged and sometimes tortuous process of deliberations between Dublin and Frankfurt.

Mr Draghi was technically correct to say that that the ECB merely noted the Irish ‘operation’ designed and undertaken by the Irish Government and the Irish Central Bank. This is because funding of Irish Bank Resolution Corporation (the wind-down vehicle for the former Anglo Irish Bank and Irish Nationwide Society) takes the form of Emergency Liquidity Assistance from the Central Bank of Ireland rather than through ECB refinancing operations. As a result, this mechanism falls under article 14.4 of the ‘Protocol on the Statute of the European System of Central Banks and of the European Central Bank’ of the European Community Treaty, which states,

‘National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB.’

It is clear that the ECB has given its ‘blessing’ to the new structure and Mr Draghi’s comment that the ECB had noted this operation ‘unanimously’ implies that it was the subject of significant discussion around the January council table and the outcome is not compromised by any significant dissent on the part of the Governing Council. Importantly, however, Mr Draghi suggested that the ECB would review the issue ‘in due time’ and his indication that he was ‘not saying this is the last word’ on the matter. This suggests, that as Article 14.4 indicates, the Governing Council will revisit the issue in the future particularly if there are any fears that it could ‘interfere with the objectives and tasks of the ESCB’—most likely though concerns that the new structure might be regarded as a form of monetary financing

At the margin, the switch from promissory notes to marketable Government bonds lessens this threat as does the plan to gradually reduce the Central Bank’s holding of these bonds. According to the Irish Central Bank, ‘The bonds will be placed in the Central Bank’s trading portfolio and sold as soon as possible, provided that conditions of financial stability permit. The disposal strategy will of course maintain full compliance with the Treaty prohibition on monetary financing.’ This statement may offer only limited comfort to some critics of the ECB’s more unconventional actions through the crisis. As the credibility of the ECB in this regard is a critically important and consistently scrutinised matter, we are likely to hear more on this point in the months ahead.

What Is The New Structure And What Does It Mean For Ireland?

According to the Minister for Finance, Michael Noonan, some €25 bio promissory notes will be replaced with a portfolio of €25 bio of long term Government bonds maturing between 2038 and 2053. The average maturity of this portfolio will be 34 years compared to an average life of 7-8 years for the promissory notes. As the promissory notes entailed payments of €3.1 bio each year for the next ten years, the new structure implies a significant near term cash flow benefit to the state and a reduction in Ireland’s funding requirement of approximately €20 bio over the coming decade.

Under the existing promissory note structure, the Government are scheduled to make interest payments of €1.9 bio in 2013, €1.8 bio in 2014 and €1.7 bio in 2015. The Taoiseach, Enda Kenny, told the Dáil today that the new variable rate structure ‘…will result in a reduction in the state’s General Government deficit of approximately €1 bio per annum over coming years, which will bring us €1 bio closer to attaining our 3% deficit target by 2015. This means the expenditure reduction and tax increases will be of the order of €1 bio less to meet the 3% deficit target.’ These remarks suggest that savings coming from the new structure will not be used to cut Ireland’s Government deficit at a faster pace. Instead, the savings will be used to reduce the scale of the budget adjustment envisaged in 2014 and 2015 from a cumulative €5.1 bio (€3.1 bio in 2014 and €2.0 bio in 2015) to €4.1 bio.

While not a ‘game changer’, a reduction of €1 bio in the budget adjustments planned for Budget 2014 could boost Irish economic growth by around 0.5% next year compared to previous expectations. This prospect of somewhat stronger growth may underpin today’s slightly more optimistic Troika statement on Ireland that notes ‘Ireland’s economic recovery is continuing and is expected to gradually gain momentum, with growth forecast to firm to over 1% in2013 and over 2% in 2014.

In conclusion, the emerging details of the new structure are probably more favourable to Ireland than most had expected. By reducing official funding requirements for the next ten years and marginally easing the scale of budget adjustments envisaged in the next couple of years, the new mechanism improves Ireland’s prospects of exiting the bailout and also increases the likelihood that the Irish economy will return to a healthier growth trajectory in coming years. As such, it should underpin positive market sentiment towards Ireland. Reflecting this, Irish bond yields fell sharply on Thursday afternoon with the 10 year yield dropping around 17 basis points, its lowest level since 2007.