Ever since European Central Bank President Mario Draghi said last July that the bank will do whatever it takes to preserve the euro, complacency has pervaded Europe’s single-currency area. Markets have weathered potential crises in Italy and Spain with surprising calm, secure in the knowledge that the ECB will save the day if needed.
This was always a false assumption, as events in Cyprus have made clear. There are significant limitations to the support the ECB is willing or able to offer, even to such a tiny island economy whose needs are easily affordable.
The ECB relies on two primary mechanisms to help euro-area countries in crisis. The first, emergency liquidity assistance, allows a country’s banks to access cheap funding from their national central bank, even when all they have left is low-quality collateral that doesn’t meet the criteria for the ECB’s standard liquidity operations. This emergency facility has helped a number of countries make it through liquidity squeezes over the past few years, keeping banks in Belgium, Greece and Ireland on life support since the beginning of the crisis in 2008.
The ECB has kept Cypriot banks alive in this way, too, providing about 9 billion euros ($11.6 billion) of financing to date. The ECB threatened to cut Cyprus off, however, if a bailout deal wasn’t agreed on with the so-called troika of international creditors -- the ECB, the International Monetary Fund and the European Commission -- by March 26.
In response to the ECB’s threat, the Cypriot parliament passed a bill on March 22, allowing for capital controls. Emergency ECB funding would have plugged the gap in bank balance sheets created by deposit flight. Without this funding, deposit flight would have to be stemmed by force of law to prevent the island’s banks and economy from imploding. This is a serious line for a euro-area country to cross: Capital controls are legal under extraordinary circumstances, but they go against the notion of freedom of goods, labor and capital that is the principle tenet of the European currency union.
The second mechanism the ECB can use to support euro-area countries is outright monetary transactions, the bond-buying program that it detailed in September. This facility has yet to be used, but its mere existence has caused borrowing costs for peripheral euro-area countries to fall significantly. Consequently, these countries have already managed to sell 28 billion euros of bonds in 2013, roughly double the figure for the same period in 2012.
Despite this renewed confidence in euro-area government debt, recent events in Cyprus have highlighted the bond-buying program’s limitations -- it can alleviate stress in the sovereign-bond markets, but that’s about it. Even if Cyprus met all the conditions to use the facility, that wouldn’t help the country avoid a banking and economic collapse.
Investors should have seen the limitations of the ECB’s intervention tools before the Cyprus bailout disaster. Sovereign borrowing costs have fallen, but as far as the real economy is concerned, most indicators released from a euro-area country in the past six months have been worse than the last. This goes not just for the weak countries but also for core countries, such as Germany.
The outright-monetary-transactions program was meant to support the real economies of peripheral countries by allowing borrowing costs for businesses across the euro area to converge. The opposite has happened. In January, borrowing costs for small- and medium-sized enterprises in Spain and Italy -- where such companies form the backbone of the economy -- rose to 6 percent and 5.8 percent, respectively. At the same time, the cost of borrowing for German small- and medium-sized companies fell, to 3.5 percent.
Even if the ECB’s two special rescue mechanisms succeed in improving and stabilizing the financial and economic environment of a euro country in crisis, these tools are powerless to address political risk in the euro area. That’s a significant weakness, because political risk has repeatedly come to the forefront of this crisis, as elected politicians seek to protect their own country’s interests in negotiations over who will end up paying for the imbalances that have developed in a fundamentally flawed monetary union.
Whatever happens in Cyprus is unlikely to ring the death knell for the common currency. A chaotic default and exit from the euro area by such a tiny economy would be disruptive, but the rest of the currency union would probably weather it. The Cyprus debacle has revealed, however, that the ECB isn’t a cure-all, and that investors’ trust in the willingness and ability of the central bank to “do whatever it takes” may be a big mistake.
If the ECB’s toolkit can’t save a country that accounts for 0.2 percent of the euro area’s gross domestic product, then how will it provide meaningful support when financial or fiscal difficulties emerge in larger countries such as Spain and Italy? This question should be keeping investors up at night, because it’s a given that such difficulties will arise -- the only question is when.
(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. She is also a senior fellow at the Atlantic Council in Washington. The opinions expressed are her own.)
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