UVA-GEM-0113 Rev. Mar. 8, 2018 Draghi’s Commitment …the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. —Mario Draghi, President of the European Central Bank (ECB)i As Arturo Rodrigo was riding the early morning Metro North train from Manhattan to Greenwich, Connecticut, in February 2018, ECB President Mario Draghi and eurozone debt markets dominated his thoughts. Rodrigo was old enough to remember the dramatic convergence in eurozone long-term rates that occurred in the late 1990s just prior to the advent of the euro. The long rates of Italy and many other eurozone countries decreased sharply, converging to the much lower German rates (Figure 1). This unprecedented decrease in borrowing costs fueled borrowing binges in Athens, Madrid, Dublin, and many other eurozone cities.1 Figure 1. Convergence in long-term bond yields (through mid-2007). DO NOT COPY 1 There are many English names for the area, including eurozone, euro zone, and euro area. This author tends to use eurozone. This case was prepared by Francis E. Warnock, the James C. Wheat Jr. Professor of Business Administration at the University of Virginia’s Darden School of Business. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2013 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality, so please submit any errata to [email protected]. Page 2 UVA-GEM-0113 Between 2003 and 2006, the spread between bond yields in Greece (and other periphery countries) and Germany averaged a razor-thin 25 basis points. When the global financial crisis (GFC) took a turn for the worse in September 2008, long rates in Germany (the core of the eurozone) fell sharply, but periphery countries such as Greece, Spain, Italy, and Ireland saw their long rates surge (Figure 2). Figure 2. Divergence in long-term bond yields (through January 2018). The crisis appeared to end in mid-2009 and, amidst hope that the worst was over, periphery long rates declined a bit. But starting in late 2009, rates in Greece and other countries spiked upward once again, and the “Great Convergence” in long rates that each periphery country had enjoyed when joining the eurozone had given way to the “Great Divergence.” In the second half of 2010, the spread between Greek and German long rates widened to 1,000 basis points. And the situation got progressively worse. By summer 2012, German yields reached a then-record low of 1.22%, whereas Greek yields were bouncing between 20% and 40%. Another end to the crisis occurred in late summer 2012, prompted by ECB President Mario Draghi’s commitment to do “whatever it takes” to preserve the euro. Markets took note: Greek yields immediately fell sharply. By summer 2014, Greek long rates had trended down to 6%, and periphery countries such as Ireland and Spain were able to borrow at five years for less than the U.S. Treasury. Perhaps the worst was over. But some, including the IMF, were skeptical: “[T]he centrifugal forces across the euro area remain serious and are pulling down growth everywhere.”ii Draghi’s “whatever it takes” talked down the high risk premiums that threatened to break apart the eurozone. AndDO in early 2018, the NOTeurozone was finally emerging COPY from a seven-year recession and strong deflationary pressures. Did Draghi actually conquer tepid growth and deflation as he did high risk premiums? He had taken a number of steps—imposing negative interest rates on banks’ excess reserves, incentivizing loans to small businesses, and a full-blown quantitative easing (QE) program that would involve EUR2.5 trillion in ECB purchases of eurozone sovereign bonds by the end of 2018. But would it be enough? Page 3 UVA-GEM-0113 Rodrigo, a strategist at a hedge fund, focused today on long-term interest rates and had two decisions to make. First, what was the path of core (i.e., German) eurozone long-term interest rates likely to be over the next year? Was the dramatic decline in German long rates over the past few years—German 10-year rates had been less than 1% since mid-2014—an aberration that would soon be reversed, or was it part of the “new normal” that would persist for some time? Second, how would periphery long rates evolve relative to core rates? That is, how would the spread between long rates in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS countries) and those in Germany evolve over the next year? Which was to be expected: another dramatic divergence in eurozone long rates or a continuation of the impressive reconvergence that began in the second half of 2012? In the background of any bond investor’s mind were debt levels (Exhibit 1) big enough to tempt any government to default. Rodrigo knew many factors influenced long-term interest rates; he would have to use his entire toolkit to address this issue.2 The evidence was in no way clear-cut. Some factors pointed toward lower German rates, some toward higher, some toward a widening of eurozone spreads (even a dissolution of the eurozone as we know it), and some toward reconvergence. The ECB and other central banks, always important for bond markets, were more important than ever at this point in history: It is estimated that central banks purchased more than all the bonds issued by G10 governments in 2016 and 2017 (how could yields not be low in that environment?), but with the Federal Reserve and Bank of England halting bond purchases and the ECB tapering (from EUR60 billion per month in 2017 to EUR30 billion monthly in 2018) central banks will only buy 40% of government debt issuance in 2018.iii With Draghi’s mother of all Band-Aids (QE) set for tapering, Rodrigo wondered, “Was Draghi’s commitment to preserve the euro enough or would the monetary union be torn apart by forces against which the central bank was powerless?” Background: The Advent of the Euro and the ECB The eurozone was best viewed as one of a series of steps toward unity in Europe. In the 1950s, when the first steps toward integration in Europe occurred, unity was a distant dream. The continent had been the scene of two world wars in just a 30-year period: World War I started out as Germany and Austria-Hungary against the United Kingdom, France, and the Russian Empire, and the European portion of World War II began as Germany and Italy against much of the rest of Europe and Russia. Considering the massive loss of life in Europe over those 30 years, integration and unity could also be seen as a path toward survival. European integration, a political necessity, came with an impressive set of acronyms. This list introduces and describes a brief history of many. European Union (EU): Long before the monetary union was established, European integration began in earnest in 1957 with the formation of a customs union—the EU—in which member countries agreed to remove tariffs on international trade among members and impose tariffs on trade with nonmember countries. The EU started with six member countries (Germany, Belgium, Luxembourg, Italy, France, and the Netherlands) and grew to 28 membersDO by 2013. Step NOTby step, the process of integration COPY deepened. European Commission (EC): The EC was an executive branch formed by EU members. Also formed were the European Court of Justice in Luxembourg and a legislative branch (the European Parliament). But the EU’s supranational powers were limited. It was bound by unanimity clauses on a variety of issues. Key decisions were made by the Council of Ministers (composed of politicians from all member countries), at times making 2 For a primer on models of interest rate determination as well as discussions on yield curves and the relationship between short and long rates, see Francis E. Warnock, “The Determinants of Interest Rates,” UVA-BP-0489 (Charlottesville, VA: Darden Business Publishing, 2006). Page 4 UVA-GEM-0113 agreements difficult to reach. The EC was particularly limited in its spending and funding abilities: its budget was about 1% of the GDP of its participating members, and it could not borrow or raise taxes at will. Exchange Rate Mechanism (ERM): Integration that began with the EU continued with a first step toward a monetary union with the 1979 formation of the ERM, a key component of the European Monetary System. In the ERM, members limited fluctuation of their currencies vis-à-vis one another. Indeed, to qualify for admittance to the ERM, a candidate country had to have limited exchange rate fluctuations vis-à-vis the core (i.e., Germany). During the ERM period, European countries still had their own currencies. Yes, there was the European Currency Unit (ECU)—a GDP- and trade-weighted average of members’ currencies—but it was more of an accounting item than an actual currency. Marks were still used in Germany, francs in France, and the national central banks still controlled monetary policies. This led to substantial strains on the system because countries’ economic cycles were not in sync; within the ERM, in a foreshadowing of tensions that would reemerge with a vengeance during the eurozone debt crisis, some countries would want to tighten monetary policy when others would want to loosen it.