A key takeaway from this report (written before the EU summit meeting) is that DB’s views on eurozone crisis resolution differ markedly from those of the German government. From the report:
While we continue to believe that the eurozone’s authorities will do whatever it takes to hold the euro together, the urgency of the need to act has risen sharply. The G20 summit in Cannes in October failed to meet the great expectations it had stirred and was almost entirely overshadowed by the market chaos sparked by the suggestion of a referendum in Greece and the subsequent departure of George Papandreou, the Greek Prime Minister.
The eurozone economy now appears to be sliding into recession which we hope will only last for a couple of quarters, although we admit something worse could happen, especially if politicians and central bankers fail to respond rapidly to the deteriorating situation.
Given the market’s entrenched scepticism, what is needed now is a big ‘Grand Bargain’, way beyond anything we’ve had so far. Indeed, this is the price Europe is having to pay for lacking enough will to date. Unfortunately, the actions required are complex and politically contentious and so will likely be prone to scepticism from markets. The bigger the intended action, the bigger the risk that things go wrong when rigorous implementation is needed.
The following two paragraphs show that Deutsche Bank (1) doesn’t support the German government’s opposition to having the European Central Bank function as the eurozone’s lender of last resort, and (2) unlike the ECB, DB sees deflation, not inflation, as a key risk.
In our opinion, three radical steps are now required. First and foremost of these is a large final buyer of government debt. We believe the European Central Bank (ECB) is the only credible source. The ECB is not allowed to buy primary issuance from governments but can buy bonds on the secondary market, as it has been doing in recent months, while noting it may not be entirely content with that course of action. True, significant purchases could be seen as a contradiction of the ECB’s statute. But the German Constitutional Court recentlydismissed lawsuits taking this line.
We think the inflation risk of such purchases is negligible, given the looming credit crunch and recession in the eurozone. Inflation is not Europe’s number one problem right now. We believe deflationary pressure should be more of a concern. The ECB could pledge to purchase a set volume of bonds, say EUR200 billion worth over the next 12 months. That on its own appears enough to finance Italy through 2012. It would be difficult for the ECB to say it is only buying Italian debt but there is no technical reason why it cannot commit to purchasing a set volume of bonds in the secondary market, exactly as it is doing right now with covered bonds.
We believe the second step needed is a big, deliverable and rapid structural reform package from Italy to convince markets it can pull through the crisis. The package needs to be proven immune from the vagaries of the economic or political cycles.
The bank favors some sacrifice of sovereignty:
Third, we need to see rapid and clear signs from the EU that fiscal integration, involving changes to treaties, is coming. We believe there has to be some sacrifice by member states of sovereignty. An example would be giving the European Council the right to veto national budgets. This is the sort of quantum leap in governance reform that the ECB is asking for.
The ECB will likely demand that if it is to launch significant bond purchasing, it has to see the second and third actions outlined above. If it launches this action without demanding any conditions, the eurozone may look weak because it would be seen to be printing money without credible political change or fiscal control. We note that would likely be poorly received by markets.
But “time is short”:
So the ECB, in our view, will have to make a leap of faith and step up its intervention on the basis of a statement of intent from the eurozone’s governments. Even a treaty revision under enhanced cooperation limited to the 17 EMU members would take several months since it would need to follow national ratification procedures. A replication of the EFSF drama is likely, with heated discussions in at least Finland, the Netherlands and Slovakia. ECB intervention will likely have to be particularly large around the key dates for national debates. Even if governments strive to get the new treaty sorted as fast as possible, we think the summer of 2012 is probably the earliest date.
In the meantime, we believe we need to move from implicit to explicit conditionality. Indeed, in its current form, the ECB’s bond purchasing follows an implicit conditionality with contacts between the ECB and the governments which never are as comprehensive and publicly debatable as memoranda of understanding (MoUs) signed withthe IMF.
This likely creates two symmetric risks. First, that public opinion in the core countries consider that the commitments of the peripheral countries are insufficient to warrant an indefinite increase in the ECB’s balance sheet. And second, that peripheral countries resent the transformation of the ECB into a benevolent economic dictator triggering ultimately a rejection of its support.
From a practical point of view, we think that an emergency European Council should be organised as soon as possible to deliver the letter of intent which could allow the ECB to step up its interventions and act as lender of last resort. Europe remains deeply mired in its sovereign debt crisis, something that is likely to dominate markets in the year ahead, and not just in Europe. The whole world has an interest in the resolution of a crisis that deepened dramatically through the fourth quarter, and enveloped more and more major economies putting European leaders on the backfoot as events threatened to overwhelm them.