German Court Ruling Is a Milestone for Euro

September 20, 2012

Tatjana Michel
Director, Currency Analysis, Schwab Center for Financial Research

At its last meeting on September 6, the European Central Bank (ECB) laid out a plan to help the financially troubled countries in the eurozone overcome the debt and banking crisis. This plan aims to ease monetary conditions in countries like Spain and Italy and to help their banks reduce exposure to low-quality sovereign bonds. The euro reacted positively to this plan and rose above 1.28 against the US dollar following the announcement.

But there was still another hurdle to overcome—legal challenges in Germany to its participation in the permanent bailout fund. On September 12, the German Constitutional Court ruled that Germany's participation in the European Stability Mechanism (ESM) is legal with the restriction that any amount above 190 billion euros ($247 billion) would have to be approved by the German parliament. The positive German court ruling is critical to the success of the ECB's bond buying plan because countries have to apply for help at the ESM before the ECB can step in with bond purchases, and Germany is slated to contribute 27% of the ESM fund. After the ruling, investors breathed a sigh of relief and the euro appreciated to above 1.29 against the dollar.

The ECB bond buying plan

The ECB's bond buying plan aims to reduce the interest rate spreads between the sovereign debt of distressed countries and eurozone core countries, such as Germany and France. This will hopefully lower borrowing costs for troubled countries so that they are able to refinance their debt at more sustainable interest rates and reduce their deficits and debt burdens. Here are the main points of the plan:

• The ECB will purchase unlimited amounts of distressed debt with maturities between one and three years on the secondary market.
• Before the ECB can buy a country's bonds, the country has to formally request a bailout from the ESM, accept the bailout terms and commit to long-term fiscal solvency.
• The ECB does not have seniority over other bond holders.
• These purchases will be "sterilized," meaning that an equal amount of higher-quality ECB assets will be sold.

Bond purchases will likely be sterilized through the selling of higher-quality bonds of countries such as Germany and France, which would narrow the interest rate spreads between distressed and good debt. This will not only bring the yield of "bad debt" down but also drive the yields of "good debt" up. Apart from that, it may lead to a deterioration of the asset quality in the ECB's balance sheet but may help improve the asset quality in the balance sheets of the national lending institutions and banks.

The announcement of the plan had a positive effect on the yields of the Spanish and Italian 10-year government bonds, which came down to around 6% and 5% in the week after the announcement, according to Bloomberg. This is well below their July 2012 peaks of 7.62 and 6.57, respectively.

What it means for the euro

The ECB's bond buying plan, the positive German Constitutional Court ruling on the legality of the ESM, and the Fiscal Compact (a treaty that limits the primary deficits of the EU countries) are positive developments for the euro because they help build confidence that the crisis is being tackled. Also, the fact that the ECB wants to sterilize the planned bond purchases is important for the European single currency, as it does not widen the central bank's balance sheet and therefore does not dilute the value of the euro as long as the ECB has enough "good" assets to sell.

This stands in contrast to the US Federal Reserve's announcement on September 13 of QE3 that will expand the central bank's balance sheet. The Fed said it will "purchase additional mortgage-backed securities at a pace of $40 billion per month" and will not sterilize the purchases. This is likely to have a weakening effect on the dollar against euro and currencies of other central banks that aren't expanding their balance sheets. The Fed also announced that it will leave interest rates unchanged until mid-2015 and will continue "through the end of the year its program to extend the average maturity of its holdings of securities" and to "reinvest principal payments from its holdings in agency-mortgage-backed securities." This is likely to be neutral for the dollar as it doesn't affect the balance sheet.

Buying time

The ECB bond buying program does not solve the various problems in the troubled countries, it mainly buys them time to implement the necessary structural reforms, tackle productivity and competitiveness gaps and refinance their banking systems without the constant stress of high and rising refinancing costs (bond yields).

Also, many European countries appear to be slipping back into recession, which can make it difficult for them to meet budget and deficit targets this year. Banks are still overloaded with non-performing loans, which they probably will have to write off. Bank lending is anemic and demand for loans is weak according to the ECB’s quarterly Bank Lending Survey. Therefore, European leaders will have to provide a growth-focused plan that will lead them out of the crisis.

Euro reaction

The EUR/USD exchange rate bottomed at a two-year low of 1.2060 on July 24, according to Bloomberg. The euro has been moving upward since the end of July, when ECB President Mario Draghi announced that everything possible will be done to save the currency.

Following the ECB’s announcement of the bond buying plan on September 6, the euro/dollar exchange rate rose from 1.26 to 1.28 and after the German court ruling on September 12, it went to above 1.29. The Fed’s announcement of another bond buying plan propelled the euro even higher. The currency pair was trading at 1.31 when this article was written.

Source: Bloomberg as of September 17, 2012.

Looking ahead

A country could still leave the euro, but the chances of that happening have diminished in our view. Greece is not likely to meet its targets anytime soon, so the likelihood for it remaining in the eurozone will depend on the willingness of the Troika (EU, ECB, IMF) to keep financing the country's shortfalls going forward.

However, if Greece were to leave the eurozone, the ECB’s bond buying plan together with the ESM could help keep contagion to other eurozone countries in check, therefore, lowering the break-up risk for the euro.

Still, the underlying debt problems are not solved and further growth-spurring programs will have to be implemented to help solve the crisis. This may take many months or even years. Until then, we are probably going to see additional disappointments as well as positive surprises.

Some big questions remain, such as:

• Will Spain have to seek ESM help after its banking sector figures are published in September/October?
• Will the Troika decide to continue financing Greece or will the country eventually leave the euro?
• Will the ESM be big enough if Spain and Italy need assistance?
• How will the German parliament react if they have to contribute more than 190 billion euros to the ESF?

These and many other important questions may need to be addressed in the near future, which will likely cause euro exchange-rate volatility to remain high. The direction of the euro also is likely to depend on the ECB’s monetary policy relative to other central banks. Overall, however, the ECB bond buying plan and the German court ruling are likely to have improved the chances for the euro’s survival and the outlook going forward.