The Daily Update - 'Whatever it takes' 5 years on

‘Whatever it takes’ - Three words that may have saved the Eurozone… for at least 5 years.

‘All the leaders of the 27 countries of Europe… said that the only way out of this present crisis is to have more Europe, not less Europe. A Europe that is founded on four building blocks: a fiscal union, a financial union, an economic union and a political union… there is more progress than it has been acknowledged… [people] underestimate the amount of political capital that is being invested in the euro… we think the euro is irreversible… Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.’

These were the words of one Mario Draghi exactly 5 years’ ago today. It was a speech that revitalised market sentiment towards Europe when Greek 10-year debt yielded 27%, and Spain Italy and Portugal yielded between 7-11%. At such unsustainable yields the ECB must have felt that it had no other option than to act as lender of last resort; Draghi’s forcing and unambiguous language gave markets much-needed assurance that no monetary tool would be spared. By the end of the year Greek yields had more than halved and have since more than halved again: to the present 5.3% level.

The ensuing lower financing costs certainly held back the implosion, but alone are not enough to bring the Eurozone economies back into balance and sustainability. 5 years’ ago, the positive sentiment that followed Draghi’s remarks incorporated hopes that the necessary fiscal policies and political consensus would soon follow. But after 3 years of can kicking Greece ended up defaulting on a $1.7bn IMF payment in mid-2015. Now after 5 years of ‘extend and pretend’ policies, including 3 bailout programmes, Greece has been able to return to positive growth territory and this week tap the markets for €3bn of 5-year debt at 4.6% (though half of the buyers were simply swapping their shorter duration paper under attractive terms).

But the underlying issues remain. Debt continues to climb beyond 180% of GDP. The IMF and Europe are still unable to reconcile their paths to sustainability. The IMF is adamant that it needs to see meaningful debt reduction. Whereas ‘European politicians worry about the domestic political consequences of granting Greece debt relief’ wrote Mohamed El-Erian last month in the Guardian - reminding everyone that the ‘IMF and EU’s quick fix isn’t enough’ and ‘still leaves Greece under the shadow of an enormous debt overhang’.

So in this regard, little has changed since 5 years ago when we wrote that, ‘the imbalances in Europe remain very large… the net foreign asset surplus of Germany (around EUR 928bn), and the almost equal deficit of Spain (EUR 982bn). The next largest amounts, the surpluses of the Netherlands and Belgium, and the deficits of Italy, and France are much smaller, in the EUR 100-300bn range.’

These imbalances remain the underlying problem, across Europe and not just in Greece (where in fact above average progress has been made). Whilst this is the case one could view investments in the likes of Greek debt as a bet on the ‘pretend and extend’ policies lasting beyond the assumed bond maturities. Looking back over the political languor of the past 5 years, another 5 looks possible. But with every day that passes investors will surely become less enamoured with the empty promises of reform, bailout funds will deplete further, political momentum vanish, all the while facing headwinds of slower growth and demographics.

The latest ‘approval in principle’ from the IMF gives Europe time enough to survive the season of elections, by which time Europe will not have quite so valid an excuse of political backlash. If no meaningful compromise is made, even after concerns of populist uprisings subside, there is every possibility that markets will wake up to the inevitabilities of unsustainable ‘pretend and extend’ policies.