How Draghi intends to "Repair" the Eurozone

Key Highlights

• A break down and analysis of Draghi’s sentiments
• “The risk of doing too little exceeds the risk of doing too much”- Mario Draghi
• Euro bound to weaken over time
• Structural reforms in the banking sector

In a speech yesterday (9^{th of} October 2014) at the Brookings Institution in Washington, Draghi gave a speech outlining his strategy for getting the Eurozone out of the current crisis and stalled growth. Though evident, the ECB president drew parallels between the US crisis during the Roosevelt administration and the current Euro crisis.

Like the US the Europe is going through a state of Recovery and Reform. For a trader, and any forex market participant the importance of understanding the ECB’s approach to the crisis cannot be understated. Since the ECB begun implementing its reform agenda, we have seen wild swings in all of the Euro pairs. The EURUSD for instance has been tumbling consistently over the last three months for over a thousand pips. Just being able to anticipate and catch such potential swings in the exchange rate can be very profitable for any market participant.

The repair strategy

Draghi elaborated his plan to carry out major ‘repairs’ throughout the Euro money system. He out lined the four fronts to his strategy for recovery and reform:

• Repairing money
  • The ECB has had to stave off Euro skeptics especially at the initial stages of the currency union. One of the major problems Europe faced was the non-integration of the banking system and the   fragility of a system where the ultimate guarantee of any European bank was disintegrated as per their originating sovereign countries.
  • To repair this, a banking Union in Europe has been envisioned to streamline and supervise banking operation within Europe. It is foreseen that better integration will harmonize operations within the union.

• Repairing Financial sector and credit allocation
  • The bank deleveraging process together with the entrance exam for banks has seen large banks in Europe increase their balance sheets by over €200bn since 2013 as they prepare to get vetted into the new banking union.
  • Another angle of approach under this same heading is to develop the capital markets and to establish a Capital markets Union for the Eurozone. This will see the Small and medium size enterprises that constitute about 66% of the private sector employment find an alternative source of finance independent from the banks. This will ensure that the SMEs are not locked out of credit access and consequently that Eurozone unemployment remains in check.

• Repairing monetary policy
  The ECB has kept interest rates low in the lower bound and has even moved into the negative territory. The expansionary monetary stance has included a series stimulus packages for the Euro area economy. The TLTRO for instance, encourages banks to loan out to private forms and increase the penetration of the effects of the monetary policy. The  necessity of this program is that as it currently stands, the composition and structure of the European financial system is that banks have to act as the intermediaries to transmit the stimulus packages to the packages.

• Repairing fiscal policy
  Draghi wants to see confidence restored in the Euro area on expenditure of public finances. There has been a lot of progress done to tighten up fiscal spending and reduce borrowing by governments but restoring credibility in the fiscal policy of the Euro system is still a major point in the reform agenda.

Putting it all together

The Euro has shown major weakness against other major currencies. From Dragh’s speech we can clearly deduce that the major causes of this weakness is the weakness in the European economy, the Banking crisis and the expansionary monetary stance of the ECB.

His closing remark that “the risk of doing too little exceeds the risk of doing too much” captures clearly the perception that the ECB has on the matter: they are willing to do much more to stimulate growth; for a trader this means a more lax monetary policy which translates to a weaker Euro in the coming years. Under these conditions, a great trading approach for longer term trading strategies is to short any rallies in the Euro and to short the Euro on any negative news form the area.

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