Author: Alastair George
In only a few weeks, European leaders will have to decide on a new ECB President to replace the incumbent Mario Draghi, whose term expires in October. Draghi has been a radical ECB president, deftly playing a difficult political hand to win support for a EUR 2.5trn ECB balance sheet expansion. In a time of crisis he offered “whatever it takes” to save the euro. We can now believe his claim that he would do enough to restore financial stability to the eurozone. Yet the ECB’s work in terms of monetary policy, regulation and eurozone financial integration is far from complete. Unlike Draghi, the incoming ECB President faces no immediate crisis. However, politically challenging further convergence of fiscal trajectories, economic growth and bank sector regulation is required to ensure the long-term viability of the eurozone project. We believe markets would applaud an ECB President offering policy continuity in the short-term combined with the experience and political skills to ultimately drive further eurozone integration.
President Mario Draghi’s key achievement was to break the taboos that had paralysed ECB policymaking and left the weaker members of the eurozone at the mercy of volatile international capital flows and financial speculators. His “whatever it takes” speech in 2012 possibly defined his ECB Presidency. This speech was followed in 2015 by an EUR 2.5trn expansion of the ECB’s balance sheet, a policy critical to re-establishing the convergence of interest rates and control over monetary policy across the eurozone. His and other ECB’s officials measured communications during his tenure, both on and off the record, have carefully guided eurozone markets away from scenarios which could have impinged on the recovery later in the decade.
Yet while investors can praise Draghi’s determination to act in a time of crisis, inflation forecasts have been consistently missed even during the eurozone’s post-crisis expansion. In this regard, the ECB is not alone, as the unanticipated absence of inflationary pressure while GDP growth accelerated was a phenomenon observed across developed markets during this decade. Nevertheless, at the end of Draghi’s tenure it leaves ECB policy at an unusual setting with negative interest rates, new credit easing initiatives underway and doveish forward guidance, all despite several years of economic recovery.
The ECB remains a relatively new institution and the euro a relatively new currency. In certain respects, the euro was sold on the perceived benefits to all sides while the drawbacks to each were downplayed. Nations which had endured periods of high inflation and high financing costs were attracted by the prospect of lower interest rates. Exporting nations desired the elimination of regular currency devaluations. However, few in favour of the eurozone project highlighted that a common currency would require convergence of much more than interest rates in order for it to succeed over the long-term. This has led to significant political tensions since the introduction of the common currency.
The necessary centralisation of bank regulation under the ECB is now underway but as of now there remains no consensus on the creation of a risk-free bond guaranteed by the eurozone as a whole, which could prevent the “doom loop” between sovereign government bonds and the local banking system. A eurozone-wide deposit insurance scheme has stalled during EU discussions, despite its obvious attractions of sharply reducing the risk of bank runs at the periphery of the eurozone.
In most cases it is not the economics which is in dispute, but political objections in respect of sovereignty and fiscal transfers which have resulted in the euro-denominated capital market remaining an unfinished and still fragmented project. The unobserved cost to growth of these outstanding monetary and banking inefficiencies in comparison to the similarly GDP-sized but sovereign states of the US and China is often overlooked, at least outside times of crisis.
We believe that markets will respond most favourably to an incoming ECB President who offers a seamless handover from Draghi in terms of technical competence, combined with a willingness and political ability to use all available tools to support the eurozone economy. However, the appointment is a very political process. An EU leader’s summit in June after the European elections will select from candidates but from a political perspective the appointment may be linked to the nationality of candidates for other senior posts, such as the replacement for EU Commission President Juncker.
Amongst the likely candidates, Benoit Coeure is well-respected in markets and fits the requirement for a continuity candidate as he was responsible for the design of the ECB’s QE program. There would be legal hurdles however, as a sitting board member of the ECB is not permitted to become President. In addition, he would have to be appointed over the current Bank of France head Francois Villeroy de Galhau, who is also a potential candidate for the job. Any French candidate may yet be contingent on a German nomination for EU Commission President, to avoid what appears to have become something of a tradition of installing a compromise candidate not from France or Germany as ECB head.
Erkki Liikanen, the former central bank head of Finland has had extensive experience in senior roles within the eurozone financial system and was notably responsible for authoring the EU’s report on structural reforms within the EU banking sector, a key area for future policy. There are concerns in respect of his age but he is reportedly a close confidante of Draghi and would therefore also represent continuity.
There has been no German national yet installed as ECB President. However, the current head of the Bundesbank, Jens Weidmann, has been a controversial figure and arguably mistaken in his earlier opposition to the ECB’s QE program. We view his appointment as unlikely and also one which would be received relatively poorly by markets given his comparatively hawkish views.
With at least three candidates for the ECB President representing varying degrees of continuity from Draghi’s policies, this may explain why the selection process has not occupied a greater amount of the market’s attention. The most likely candidates have all supported the ECB’s QE program and are unlikely to significantly alter the currently loose stance of monetary policy in the short-term. For the longer-term, a candidate who can overcome national governments’ objections to debt mutualisation in order to create a genuinely European capital market would enable a further convergence of the eurozone economies and would also underwrite the future of the euro.