European Economics Analyst

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1 Issue No: 15/29 Economics Research Whatever it took; whatever it takes Whatever it takes is subject to new challenges Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Never before in the field of central banking has so much impact owed to so few words. Three years ago, Mr. Draghi s famous intervention proved the seminal moment in arresting adverse market trends that posed an existential threat to the Euro as sovereign default, financial crisis and peripheral exit loomed. as source of threats to Euro shifts from markets to politics But the success of whatever it takes is now subject to new challenges. The source of stress in the Euro area has shifted from financial markets to the political domain: the irrevocability of Euro adoption can no longer be taken for granted. Different sources of tension may require different responses. What it took to stablise the Euro area in 2012 may not be what it takes to do so today. Within our mandate is becoming more controversial In this context, the hitherto somewhat neglected qualification to Mr. Draghi s famous intervention that the ECB will act within our mandate will come to matter more. We do not doubt Mr. Draghi s willingness to do whatever it takes. His actions speak as loudly as his words in that respect. But the domain of his actions specifically, their compatibility with the ECB s mandate is likely to become a topic of increased debate. And while Mr. Draghi and his colleagues have interpreted their mandate broadly (too broadly for the comfort of the German economic establishment), events in Greece have also established clearer limits. Decisions regarding membership of the Euro area lie in the political domain. But actions will be enough to preserve the Euro The ECB cannot resist the will of a country that chooses to leave the Euro area unilaterally. Nor can the ECB maintain the membership of a vulnerable country in the face of a broad-based unwillingness on the part of other Euro area members to assume the implied financial risks. But we believe political commitment to the Euro remains high. Mr. Draghi s preparedness to do enough underpins the Euro s survival. But membership of individual countries relies on their own political will. Huw Pill +44(20) huw.pill@gs.com Kevin Daly +44(20) kevin.daly@gs.com Dirk Schumacher +49(69) dirk.schumacher@gs.com Goldman Sachs AG Andrew Benito +44(20) andrew.benito@gs.com Alain Durré +33(1) alain.durre@gs.com Goldman Sachs Paris Inc. et Cie Lasse Holboell Nielsen +44(20) lasseholboell.nielsen@gs.com Matteo Leombroni +44(20) matteo.leombroni@gs.com Pierre Vernet +44(20) pierre.vernet@gs.com This is the last before we take a break for the summer. We will resume publication in September. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to The Goldman Sachs Group, Inc. Global Investment Research

2 Whatever it took; whatever it takes Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. ECB President Mario Draghi Remarks at the London Global Investment Conference 26 July 2012 Never before in the field of central banking has so much impact owed to so few words. Three years on, we take stock. Much has changed in the intervening period. Relative to the existential risks faced by the Euro in 2012, at present market conditions are benign and the stability of the single monetary policy more secure. But as recent experience in Greece demonstrates the Euro area continues to be riven by tensions, which the authorities strive to contain. Mr. Draghi s pledge remains central to these efforts. In this week s, we assess whether the commitments made in July 2012 remain sufficient to maintain relative calm in the Euro area, and render monetary union more workable. As the Greek episode has shown, the source of stress in the Euro area has shifted from financial markets to the political domain. 1 With elections in Portugal, Spain and Ireland in the coming months, there is much scope for further political challenges to Euro market stability. Different sources of tension require different responses. What it took to stabilise the Euro area in 2012 may not be what it takes to do so today. And the efforts required increasingly lie outside the traditional remit of central banks. All this points to the (hitherto somewhat neglected) qualification to Mr. Draghi s famous whatever it takes intervention playing a more important role going forward. Within our mandate will matter more. As efforts to make the Euro area more workable become increasingly political, interpretation of the ECB s mandate will be both more central and more controversial. Greece has offered a foretaste but there is more to come. Ultimately, we think that Mr. Draghi s preparedness to do enough will indeed be sufficient to preserve the Euro and underpin the integrity of the Euro area in the long run. But doing enough is a two-way street, and the political will of member countries (something that will continue to be tested in the short and medium term) will need to meet Mr. Draghi half way. Whatever it takes The past. It is important to recall the fraught events of mid-2012 to place Mr. Draghi s remarks in context. In late July 2012, the Euro area financial sector was in acute crisis. The existence of the single currency came into genuine doubt. Spanish and Italian 10-year sovereign yields reached levels above 7½%pa (Exhibit 1); 2- year rates were approaching 7%pa. The flattening of the government yield curves at levels inconsistent with fiscal and macroeconomic sustainability threatened a seizing up of the sovereign market. And, given the central role played by that market in the wider functioning of the financial system, the stability of the banking sector was brought into question. Deposit flight picked up. Bank funding markets dried out. In this environment, the threats of sovereign default, financial collapse and Euro exit were real and immediate. 1 Hence our focus on political developments at the beginning of the year. See: Europe s new politics: A populist challenge to the mainstream, 15/01 and Elections and economics, European Economics Analyst 15/02. Goldman Sachs Global Investment Research 2

3 Exhibit 1: Whatever it takes reversed the adverse trend in peripheral yields year government bond yields. % "Whaterver it takes" Sovereign bond purchases begin % Italy Spain Source: Bloomberg, Goldman Sachs Global Investment Research Two phenomena drove these developments: Self-fulfilling prophecy peripheral countries trapped in a bad equilibrium; Euro financial markets seize up, fragmenting along national lines. As concerns about sovereign credit quality and Euro exit rose, credit and convertibility risk premia became embedded in peripheral yields. The resulting rise in sovereign spreads drove funding costs to levels that threatened fiscal sustainability. The consequences of the implied tightening of financial conditions for economic activity and employment creation brought the political sustainability of Euro membership into question. As a result, peripheral economies fell into a self-fulfilling trap. Concerns about default and exit served to create financial tensions and concerns about sustainability, which in turn validated those concerns. 2 Teufelskreis the toxic interaction between stressed sovereign and bank balance sheets. European banks typically hold a large portfolio of domestic sovereign debt: a weakening of the sovereign balance sheet may raise concerns about the solvency of banks. At the same time, banking sector problems weaken sovereign balance sheets given the (often implicit) government guarantees provided to the financial sector. 3 As a result, sovereign and banking crises are inextricably linked. Problems in funding the public sector immediately lead to wider problems funding the private sector, owing to dysfunction in the banking system. And vice versa. Mr. Draghi s intervention (and in particular its institutional manifestation in the ECB s outright monetary transactions (OMT) programme) addressed the former concern. Simply by guaranteeing peripheral sovereign debt would roll over at yields consistent with fiscal and macroeconomic sustainability, the OMT ruled out the possibility of 'self-fulfilling crises' emerging in the manner described above. 2 See: Europe's 'red line', 12/20. 3 See: Banking union at two: Cautious optimism and a cautionary tale, 14/25. Goldman Sachs Global Investment Research 3

4 Exhibit 2: OMT re-coordinates private market expectations on a good equilibrium Policy change Central bank issues put options on sovereign debt by announcing commitment to buy should yields rise excessively Default risk premium No default risk premium Elevated credit risk Bad equilibrium High sovereign yield Eliminate credit risk Good equilibrium Low sovereign yield Fiscal position unsustainable Stronger fiscal position Source: Papeles de Economia Española (June 2014). The advent of banking union (with the specific objective of breaking the toxic link between sovereign and bank balance sheets) addressed the latter concern. The ECB s assumption of supervisory responsibility for Euro area banks is paving the way to a single resolution mechanism and a common fiscal backstop for the banking sector (even if efforts to create area-wide deposit insurance have proved more hesitant thus far). While still a work in progress, banking union as it stands represents significant progress relative to the regime that prevailed in For the most part, these interventions have proved successful. For example, speaking at his press conference in July 2013, Mr. Draghi concluded that: the OMT has produced universally acknowledged benefits for everybody. We concur with this assessment: peripheral yields fell to more reasonable levels and a semblance of market stability was re-established, all without the need for purchases to take place under the OMT. Shifting from a bad equilibrium to a good equilibrium by recoordinating private expectations on a more desirable outcome has proved to be a successful strategy. The present. The threat of Euro exit is no longer founded primarily in stressed economies falling into a bad self-referential equilibrium. Rather than owing to endogenous selffulfilling financial market dynamics, the biggest threat to the integrity of the Euro area as it stands now stems from political choices. Admittedly (and as we anticipated), the outcome of recent tense negotiations between Greece and its creditors has been a new accommodation that preserves Greek membership of the Euro area. The principle that adoption of the Euro is irrevocable has been maintained, at least in theory, even if the path to a third adjustment programme has proved bumpy (as we also expected) and final agreement is yet to be achieved. Yet despite this outcome, in our view the irrevocability of Euro adoption has been challenged by recent events and revelations. German Finance Minister Wolfgang Schaeuble s proposal for a 'time-out' in Greece's membership of the Euro area during the recent negotiations achieved widespread support. In practice, such a time-out would likely lead to a more permanent exit. Goldman Sachs Global Investment Research 4

5 Former Greek Finance Minister Yanis Varoufakis has recently described various preparations made for the creation of domestic Greek liquidity to circulate in parallel with (or in place of) the Euro. While such preparations are a natural part of contingency planning (and we considered the potential introduction of IOUs or scrip in our own analysis), the depth of these initiatives suggests the possibility of exit was envisaged. Although 'Grexit' was ultimately avoided, key decision makers were clearly prepared to countenance it during recent negotiations, apparently in a manner that went beyond what we have seen in the past. This begs the question of whether Mr. Draghi s commitment to do whatever it takes as has become manifest not only in the OMT programme, but also in other new policy instruments (sovereign purchases, T-LTROs) and the professed willingness to do more, as needs demand is sufficient to contain convertibility risk in the face of such explicit political discussion of exit. In recent work, we took the view that the ECB cannot resist the will of a country that chooses to leave the Euro area unilaterally. And the ECB s capacity to maintain the membership of a vulnerable country, in the face of a broad-based unwillingness on the part of other Euro area members to assume the financial risks associated with sustaining the membership of that vulnerable country, is also likely to be heavily circumscribed. In the narrow sense, this reflects the need for an ESM programme to be agreed before the OMT can be activated. It is hard to see how such agreement would be forthcoming in the cases outlined above. In a broader (and more relevant) sense, our view reflects the assessment that in a Euro area of nation states with national political constituencies, there are limits to the extent sovereignty can be transferred to the supranational level. We do not doubt Mr. Draghi s willingness to do whatever it takes. His actions speak as loudly as his words in that respect. But the domain of his actions specifically, their compatibility with the ECB s mandate is likely to become a topic of increased debate. Within our mandate In the bulk of our commentary on Euro area developments, we like most others have adopted the shorthand whatever it takes to label Mr. Draghi s July 2012 intervention. And it was the willingness to act decisively signaled by this part of his statement that proved decisive in halting and reversing the adverse market trends that posed an existential threat to the Euro. Yet that focus has led to some neglect of the caveat he also included: the ECB would act within its mandate. For sure, Mr. Draghi and his colleagues have interpreted their mandate broadly too broadly for the comfort of the German conservative economic establishment. In particular, efforts to maintain the integrity of the Euro area and ensure the transmission of monetary policy in by-passing market blockages and/or acting to reactivate moribund markets have gone beyond the traditional scope of monetary policy (and in some respects beyond the scope of initiatives taken in other jurisdictions). These efforts have proved controversial. For example, while the European Court of Justice has now ruled in favour of the OMT, the tortuous legal challenge continues through the German Constitutional court. 4 Other legal challenges (e.g. to aspects of the ECB s sovereign purchase programme) have also been considered. When defining the limits to whatever it takes, recent developments in Greece have served to refine Mr. Draghi s definition of the ECB s mandate. Limits have been established. More specifically, when commenting on the Governing Council s attitude towards the 4 See: ECJ ruling on OMT removes legal uncertainty on its activation but creates the potential for a 'constitutional deadlock', European Economics Daily 18 June Goldman Sachs Global Investment Research 5

6 provision of emergency liquidity assistance (ELA) at his July press conference, Mr. Draghi offered two remarks: The ECB has acted within its mandate and will continue to do so, under the assumption that Greece will remain a member of the Euro area This statement points to a broad interpretation of the ECB mandate: rather than speculating on the political context, the ECB will continue to offer access to Eurosystem facilities (including ELA and refinancing operations) in line with its standing rules. It is not up to the ECB to decide who is a member and who is not. [That] is entirely within the responsibility both of the Greek Government and of the Member States. This statement limits the ECB s mandate: it is the responsibility of governments to decide which countries are (or remain) part of the Euro area. By implication, if governments were to decide on exit, then the ECB s supply of liquidity to those countries would cease. At face value, these two statements are no more than common sense. They capture and confirm our established view that the ECB can neither resist the will of a country that chooses to leave the Euro area unilaterally nor maintain the membership of a vulnerable country in the face of a broad-based unwillingness on the part of other Euro area members to assume the implied financial risks. Yet there is also some tension between the two statements. If the ECB is not to decide whether a country is part of the Euro area, then basing its actions on the assumption that this is the case may prove risky. Moreover, the statements identify concrete limits to the ECB s ability to contain Euro area stresses. If markets have neglected the caveats to whatever it takes in the past, making these limits concrete in an environment in which political decisions to exit can no longer be ruled out (and may threaten to broaden, given the political outlook) may have wider implications. It will be enough In the near term, we see little risk of market dislocation stemming from limits to the ECB s capacity to preserve the integrity of the Euro area. We believe political commitment to the Euro remains high: even in Greece, the incumbent government was ultimately prepared to accept an invasive and aggressive adjustment programme in order to retain the Euro. In Mr. Draghi s eyes, the challenges posed by Greece point to the need for further efforts to strengthen the Euro area, via governance and economic reform. Later in his press conference, Mr. Draghi recognised that: this union is imperfect. And being imperfect, it is fragile, it is vulnerable, and it does not deliver all the benefits that it could if it were to be completed. So the future now should see decisive steps on further integration. In line with his previous activism, he will continue to work to create a macroeconomic environment conducive to reform, as well as chivvying the national and European authorities to reform further and act in concert. In this respect, Mr. Draghi s preparedness to do enough continues to guarantee the preservation of the Euro and underpin the integrity of the Euro area (as he promised three years ago). But it is becoming increasingly apparent that membership of individual countries relies on their own political will. And that has been tested in some cases and is likely to be tested again in the future. Huw Pill Goldman Sachs Global Investment Research 6

7 Key European Indicators Financial conditions eased in the Euro area over the past few months, notwithstanding the recent bond correction European financial conditions Index Jul. 2008=100 Tighter Conditions Source: Goldman Sachs Global Investment Research. Euro area UK Sweden Norway Our Euro area Current Activity Indicator points to growth of 1.3%qoq annualised Euro area GDP, Current Activity Indicator Business sentiment has moved sideways in the Euro area recently, while in Switzerland confidence has picked up European business sentiment Index 40 Euro area Composite PMI UK Composite PMI 35 Switzerland Manufacturing PMI Sweden Manufacturing PMI Source: Markit, SVME, Swedbank, Goldman Sachs Global Investment Research. Our UK Current Activity Indicator is consistent with growth of 2.4%qoq annualised UK GDP and Current Activity Indicator % qoq annl % qoq annl Euro cai - full set -8 UK cai - full set -10 gdp qoq annl -10 gdp qoq annl Source: Haver Analytics, Goldman Sachs Global Investment Research. Bank lending rates to companies are showing greater signs of convergence at historically low levels % pa, interest rates on business loans up to 1mn with maturity between 1 and 5 years % 3.0 Germany France Italy Spain Source: Goldman Sachs Global Investment Research Source: Haver Analytics, Goldman Sachs Global Investment Research. We expect inflation to rise sharply at the end of 2015 owing to base effects in both the Euro area and the UK Inflation forecasts % yoy Euro area HICP UK CPI GS Forecast Source: Eurostat, ONS, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 7

8 Main Forecasts Economic Forecasts GDP Consumer Prices Current Account Budget Balance (Annual % change) (Annual % change) (% of GDP) (% of GDP) Euro area Germany France Italy Spain UK Switzerland Sweden Denmark Norway* Poland Czech Republic Hungary *Mainland GDP growth Source: Goldman Sachs Global Investment Research Interest Rates (%) Spot Forecast* Forward Forecast* Forward Forecast* Forward Forecast* Forward Germany 3M Y UK 3m Y Switzerland 3M Y Sweden 3M Y Norway 3M Y Source: Goldman Sachs Global Investment Research, Bloomberg. Close 29 Jul *GS end-year forecast Goldman Sachs Global Investment Research 8

9 European Calendar Focus for the Week Ahead Euro area harmonised CPI and core CPI are released tomorrow. We forecast an above-consensus reading for core CPI of +0.9%. Manufacturing PMIs will be published on Monday, following the flash estimates that are released for the major European countries on Friday, July 24. The Composite and Services PMIs will be announced on Wednesday morning. On Thursday, the Bank of England will hold its August Monetary Policy Committee meeting, with the new arrangements for a press conference and immediate publication of the minutes and Inflation Report employed for the first time. We expect no change in Bank Rate. Euro area PMI data are slowly trending upwards Index 40 Euro area 35 Germany France Sources: Eurostat, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 9

10 Economic Releases and Other Events Fri 31 Jul Time Forecast Previous Period Country (UK) Economic Statistic GS Cons. mom/qoq yoy United Kingdom 00:05 GFK Consumer Confidence Jul France 07:45 Consumer Spending Jun +1.6%yoy +0.1%mom +1.8% Italy 09:00 Unemployment Rate Jun P +12.3% +12.4% Norway 09:00 Unemployment Rate Jul 3% +2.8% Italy 10:00 Harmonised CPI Jul P +0.3%yoy +0.3%yoy +0.1%mom +0.2% Euro area 10:00 Harmonised CPI Jul +0.22% +0.2%yoy +0.2% Euro area 10:00 Unemployment Rate Jun 11% +11.1% Euro area 10:00 CPI - Core (nsa) Jul A +0.88% +0.8%yoy +0.8% Mon 3 Aug Sweden 07:30 PMI - Manufacturing Jul Spain 08:15 PMI - Manufacturing Jul 54.5 Switzerland 08:30 PMI - Manufacturing Jul 50.0 Italy 08:45 PMI - Manufacturing Jul 54.1 France 08:50 PMI - Manufacturing Jul F 49.6 Germany 08:55 PMI - Manufacturing Jul F 51.5 Euro area 09:00 PMI - Manufacturing Jul F United Kingdom 09:30 PMI - Manufacturing Jul 51.4 sa Tue 4 Aug Norway 08:00 PMI - Manufacturing Jul United Kingdom 09:30 PMI - Construction Jul 58.1 Wed 5 Aug United Kingdom 00:01 BRC Sales Monitor Jul 1.3% Sweden 07:30 PMI - Services Jul 54.9 Switzerland 08:15 Consumer Prices Jul +0.1%mom 1% Spain 08:15 PMI - Composite Jul 55.8 Spain 08:15 PMI - Services Jul 56.1 Italy 08:45 PMI - Composite Jul 54.0 Italy 08:45 PMI - Services Jul 53.4 France 08:50 PMI - Composite Jul F 51.5 France 08:50 PMI - Services Jul F 52.0 Germany 08:55 PMI - Composite Jul F 53.4 Germany 08:55 PMI - Services Jul F 53.7 Italy 09:00 Industrial Production Jun +0.9%mom +3% wda Euro area 09:00 PMI - Composite Jul F Euro area 09:00 PMI - Services Jul F United Kingdom 09:30 PMI - Composite Jul 57.4 United Kingdom 09:30 PMI - Services Jul 58.5 Euro area 10:00 Retail Sales Jun +0.2%mom +2.4% Thu 6 Aug United Kingdom 09:00 New Car Registrations Jul +12.9% United Kingdom 09:30 Manufacturing Production Jun +0.1%mom 1% United Kingdom 09:30 Industrial Production Jun -0.1%mom +2.1% United Kingdom 12:00 BoE Monetary Policy Meeting Aug On hold On hold +0.5% Fri 7 Aug Switzerland 06:45 Unemployment Rate Jul +3.3% sa Germany 07:00 Industrial Production Jun +2.1% France 07:45 Industrial Production Jun +2.8% Spain 08:00 Industrial Production Jun +3.4% sa Norway 09:00 Manufacturing Production Jun 2.6% wda United Kingdom 09:30 Trade Balance Jun 0.0 Source: Bloomberg, Goldman Sachs Global Investment Research. Economic data releases are subject to change at short notice in calendar. Complete calendar available via the Portal Goldman Sachs Global Investment Research 10

11 Disclosure Appendix Reg AC We, Huw Pill, Kevin Daly, Dirk Schumacher, Andrew Benito, Alain Durré, Lasse Holboell Nielsen, Matteo Leombroni and Pierre Vernet, hereby certify that all of the views expressed in this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships. Unless otherwise stated, the individuals listed on the cover page of this report are analysts in Goldman Sachs' Global Investment Research division. Disclosures Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. 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