>The Draghi character test in World Stock Market (CLSA)

Stockholm

The short-term direction of world markets has now become a bet on the true character of the

new ECB President Mario Draghi. As discussed here last week (GREED & fear – Action time?, 1

December 2011), the key issue for investors ahead of this latest EU summit is whether

sufficient consensus can be achieved on the path to fiscal integration to give the ECB an excuse

to start monetising debt. For such a move would clearly be as bullish for equities as it likely

would be bearish for the euro.

The reason why the character of Draghi has become all important is that it is clear that the

compromise agreed by Nicolas Sarkozy and Angela Merkel in Paris earlier this week does not

establish the groundwork for a credible fiscal union. For this reason a conservative ECB boss

would not view it as a reason to pursue debt monetisation. But if the ECB boss is a politician,

looking for an excuse to monetise, then the central bank’s reaction to the new agreement will

be different. Note last week that Draghi said more could be done from a monetary policy

perspective if a more resolute approach to fiscal integration was agreed. To be precise, Draghi

told the European Parliament in Brussels on 1 December that “a new fiscal compact” is

definitely the most important element to start restoring credibility, and that “other elements

might follow, but the sequencing matters. And it is first and foremost important to get a

commonly shared fiscal compact right”.

This leads on to the point why the latest Franco-German compromise is not really credible

assuming, as is likely, the same sort of deal is agreed at the coming summit to be held on 9

December. The main reason why is that the new framework is not so different from the

Eurozone’s old “Stability and Growth Pact” which proved such a failure in maintaining fiscal

discipline. The reason why it is not so different is because national governments will still have

the final say on budgets. The reason this is the case is because Frau Merkel has seemingly

backed off from her earlier demands that the budget rules be policed by a supranational body

like the European Commission or the European Court of Justice. In this respect, the clue as to

Germany’s more conciliatory approach is that Frau Merkel travelled to Paris to meet an

obviously delighted Sarkozy for their Monday meeting ahead of Friday’s summit.

This raises the issue of why Frau Merkel has agreed on the above approach. The answer, based

on the information gleaned by GREED & fear during a visit to Berlin last week, is lobbying from

Germany’s own financial establishment that the crisis in European banking has become systemic. This financial crisis also has a German aspect. To cite just one example, the current market capitalisation of Germany’s second largest bank, Commerzbank is only €7.3bn, and this is after a 21% rally from the recent low reached on 23 November (see Figure 2 in report).

True, the German demand for greater collective fiscal discipline will derive some comfort from

the agreement that each Euro state will be required to incorporate so-called “debt brakes” into

the constitution. The concept of a “debt brake” is borrowed from Germany’s own federal

system, where the debt brake essentially prohibits the Federation and the Länder from

borrowing to finance their budgets. This rule has been enshrined in Germany’s constitution. The

European Court of Justice will also be empowered to rule on individual countries’ behaviour in

achieving fiscal discipline. It is these sorts of points which may give Draghi the excuse if he is

looking for one to hail a so-called “fiscal compact”.

The other major development this week again involves a concession from Frau Merkel. She has

reportedly agreed that private sector bondholders, most notably Eurozone banks, will in future

not be compelled to take losses on their sovereign lending in the Eurozone, as they have been

in the case of Greece. This marks in GREED & fear’s view a massive retreat from the German

leader’s previous stance driven by moral hazard concerns, and also by demands from the left

wing of German politics that banks should take losses. Again, concern about financial sector

systemic risk appears to have driven this Merkel backdown. But it is, of course, much easier

asserting the principle that there will be no sovereign defaults than deciding who is ultimately

responsible for all the sovereign borrowings. And here the likes of Mr Sarkozy, and his friends in

the periphery, will be looking to Mr Draghi’s printing press to relieve them of the burden. Does

Frau Merkel really agree to that? GREED & fear doubts it.

To read report in detail: DRAGHI CHARACTER TEST

RISH TRADER