Draghi in Battle Mode on Day One as Debt Crisis Torments ECB

By Jeff Black and Simon Kennedy
Oct. 31 (Bloomberg) -- Jean-Claude Trichet had almost four years to settle into the role of European Central Bank president before being thrown into crisis-fighting mode. Mario Draghi goes to battle on day one.
Draghi, who succeeds Trichet tomorrow, becomes chief guardian of the euro with its 17-nation economy facing the risk of recession, a victim of the two-year-old sovereign debt crisis politicians are struggling to fix. As ECB president, he will be the second most powerful central banker in the world after Federal Reserve Chairman Ben S. Bernanke, and a key figure in the struggle to restore investor confidence in Europe’s monetary union.
“This will be a baptism of fire for Draghi,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam.
“It is challenging to be ECB president in any environment, let alone in the midst of a serious crisis.”
As some governments look to him to back up their efforts with continued bond buying and perhaps lower interest rates, Draghi has to lead ECB policy makers at odds over how much more they can do without compromising the bank’s independence or main goal of stable prices. In a sign of the pressure Draghi faces, French President Nicolas Sarkozy said he spoke with him last week and was “convinced” the ECB will keep purchasing sovereign debt to ease strains on financial markets.

Fiscal Pressure

With a Nov. 3-4 Group of 20 summit looming, European nations from Greece to Italy are under pressure to restore fiscal order and bring an end to a crisis that’s threatening global growth.
While euro-area leaders bolstered their crisis-fighting tools at a late-night summit ending Oct. 27, a lack of detail over how the region’s rescue fund will be enlarged and how a writedown of Greek debt should be implemented may sow doubts in the weeks ahead.
Pacific Investment Management Co. Chief Executive Officer Mohamed El-Erian says the euro area has to shrink to survive, while Nobel Laureate Paul Krugman said on Oct. 27 that the ECB will ultimately have to print more money to master the debt crisis.
The governor of Italy’s central bank until the stroke of midnight, Draghi’s stance on the ECB’s bond purchases will be scrutinized after the policy contributed to the resignations of Executive Board member Juergen Stark and former Bundesbank president Axel Weber. Chairing his first ECB policy meeting on Nov. 3, he may also face pressure to cut rates four months after Trichet raised them.

‘Impossible Tasks’

“Friends tell me that I rarely shy away from impossible tasks,” Draghi, 64, said at Trichet’s Oct. 19 farewell gala.
It was a rare personal comment from a policy maker who has made few public speeches or appearances since becoming Trichet’s heir-apparent in February.
“He has been exceptionally diplomatic so it’s not clear where he stands on certain questions,” said Klaus Baader, co- chief European economist at Societe Generale SA in London. “It may be an advantage so he’s not battling a preconception, but there may also be a degree of confusion.”
The need to reinforce a break with Italy’s profligate reputation and secure the trust of inflation-fearing Germans will likely put pressure on Draghi at the ECB, said former U.K.
Prime Minister Gordon Brown.

Inflation Hawk?

“He’s a good guy, but he’s an Italian,” Brown, who worked with Draghi at international financial summits, told Bloomberg News in Washington on Oct. 20. “He’ll always be under pressure, as long as he’s in this job, to be hawkish on inflation.”
Inflation accelerated to 3 percent in September, breaking the ECB’s 2 percent limit for a 10th straight month. Still, signs of recession mean Draghi may be considering whether to cut interest rates just four months after the benchmark was lifted for a second time this year to 1.5 percent.
Data last week showed Europe’s services and manufacturing output contracted at the fastest pace in more than two years in October and European economic confidence dropped to the lowest since 2009.
While Morgan Stanley economists predict a rate reduction this week, former ECB analyst Tobias Blattner of Daiwa Capital Markets said Draghi will probably resist taking action until December to reinforce his inflation-fighting credentials and see new forecasts from the ECB’s economists.

‘Limited’ Influence

Those hoping for a change of course from a Draghi-run ECB are likely to be disappointed, said Michael Schubert, an economist at Commerzbank AG in Frankfurt. The Italian has been on the bank’s Governing Council since 2006 and the role of chairman is limited to finding a consensus among its 22 other members rather than striking out alone.
“Draghi can’t do much different from Trichet,” said Schubert. “His influence is rather limited.”
Trichet has said he expects the revamped European rescue fund to take over the role of bond buying from the ECB. While the European Financial Stability Facility is now securing that ability and governments are working to increase its spending capacity, some economists say the ECB will have to remain in markets.
“The role which the ECB will or will not play remains crucial,” said Holger Schmieding, chief economist at Joh Gossler Berenberg & Co in London. “Without ECB support, the chances of this deal putting an end to the euro crisis now are probably below 50 percent.”

Bond Program

The ECB should be even bolder than its current efforts to stabilize markets, said Paul De Grauwe, a professor at the Catholic University of Leuven in Belgium. Draghi should use the bank’s unlimited resources to aggressively buy the bonds of governments viewed as solvent yet illiquid, such as Italy’s, to entice investors back into markets, he said.
The ECB began buying Italian and Spanish bonds in August, restarting a purchase program that has now racked up a total of
169.5 billion euros ($242.6 billion). Yet Italy’s 10-year bond yield rose 11 basis points today to 6.12 percent, the highest since the ECB started intervening and 399 basis points above the German equivalent. The yield on Italian five-year bonds jumped to 5.89 percent, a euro-era record.
Stark, Weber and current Bundesbank President Jens Weidmann have criticized the purchases, saying they blur the line between fiscal and monetary policy. The ECB says the program is aimed solely at ensuring proper transmission of its interest rates, and argues it is not printing new money, known as quantitative easing, because it “sterilizes” the bond buying by absorbing the same amount of money from the banking system.
While Draghi said on Oct. 26 the ECB remains “determined to avoid a poor functioning of money and financial markets,” he reiterated that its unconventional measures are “temporary by nature.”

The ‘Quiet’ Italian

Orphaned in his teens, Draghi was the first Italian to secure a doctorate in economics from the Massachusetts Institute of Technology, where Bernanke also studied.
“Mario was very quiet, but very good,” said Nobel laureate Robert Solow, who taught him at MIT. “I thought he’d be a professor and have an excellent reputation as an academic economist in Italy, but those same skills will certainly help him as ECB president.”
After teaching economics and working at the World Bank and then his country’s finance ministry, Draghi joined Goldman Sachs Group Inc. in 2002 as a London-based managing director and vice chairman of its international division.
While he spent just three years there, the link was cited as an obstacle to him running the ECB as authorities questioned Goldman’s involvement in currency swaps that helped Greece hide the extent of its deficit and debt. Draghi denies any involvement in the trades.

Consensus Builder

In 2005 he was appointed to run the Bank of Italy, and four years later twinned that job with helming the Financial Stability Board, which was tasked with re-writing the rules of global finance.
At the FSB, Draghi relied on consensus building rather than arm-twisting, according to an FSB board member who spoke on condition of anonymity. Such an approach meant Draghi, a father of two, was able to unite transatlantic differences over how banks should be kept on a leash, the person said.
From his new office 35 floors above Frankfurt’s banking district, Draghi may use his eight-year term to move the ECB toward a greater role in financial stability, said Thomas Mayer, chief economist at Deutsche Bank AG in Frankfurt.
Europe has since January this year had its own financial oversight body, tasked with sounding the alert if risks in the banking system build up. The European Systemic Risk Board is housed at the ECB’s headquarters and chaired by its president.
“We have seen a change in the central bank paradigm and it’s clear the focus on price stability is no longer enough,”
said Mayer. “You have to look after financial stability.
Trichet built the makeshift bridge to this new world. Draghi’s task is to decide where the balance is.”