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Draghi Hails ‘Positive Contagion’ as Euro Markets Stabilize

European Central Bank President Mario Draghi
European Central Bank President Mario Draghi, center, arrives for the news conference at the bank's headquarters in Frankfurt. Photographer: Ralph Orlowski/Bloomberg

European Central Bank President Mario Draghi said the euro-area economy will slowly return to health in 2013 as the region’s bond markets stabilize after three years of turmoil.

“We have signs that fragmentation is being gradually repaired,” Draghi told reporters in Frankfurt today after the ECB kept its benchmark interest rate at 0.75 percent. “We spoke a lot about contagion when things go poorly but I believe there is a positive contagion when things go well. And I think that’s also what is in play now. There is a positive contagion.”

Draghi chaired the Governing Council’s first decision of the year as the crisis that has rampaged through the economy since early 2010 shows signs of waning. The ECB’s pledge to buy as many government bonds as needed, plus “significant” political progress on melding the euro’s 17 economies together, has diminished concerns the currency bloc would break up.

“A gradual recovery should start” later this year as ECB measures work their way through the economy, Draghi said.

Spain’s 10-year borrowing costs, which hit a euro-era record of 7.75 percent in July, today fell below 5 percent for the first time since March after a bond sale. The euro climbed the most in four months against the dollar, rising 1.2 percent to $1.3219. The currency advanced to the highest since July 2011 against the yen.

Powerful Influence

“The dramatic improvement in financial conditions in the euro zone is exerting a powerful influence on the ECB Governing Council,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, in an e-mail. “The ECB is sitting firmly on its hands in the hope that the upturn in sentiment will eventually filter through to the real economy.”

Draghi stressed that it’s too early to claim success. Four countries, including Greece and Spain, are still in bailout programs, the euro region’s economy is still in recession and Italy faces elections next month that could bring fresh turmoil to the euro’s third-largest economy.

Risks to the outlook are on the “downside,” and the need for balance sheet adjustments and “persistent uncertainty” continue to weigh on growth, he said.

Still, Draghi felt comfortable enough to read a list of improvements in markets over recent months, claiming ECB measures had helped to bring about the calm.

Market Improvements

“Bond yields and country CDSs are much lower,” he said. “Stock markets have increased. Volatility is at a historical minimum.”

Those signs of improvement led the Governing Council to “see no reason” to change its outlook for price stability and the decision to keep rates unchanged was unanimous, he said.

“Inflation rates are expected to decline further to below 2 percent this year,” Draghi said, adding that risks to the inflation outlook remain “broadly balanced.’

“If you look at the overall landscape, you would see a significant improvement in financial market conditions and a broad stabilization of market indicators,” the ECB President said.

“A rate cut this year seems more and more unlikely, unless the economic recovery disappoints in strength or timing,” said Christian Schulz, senior economist at Berenberg Bank in London. Still, “the improvements are not strong nor quick enough to cause any concern about upward price pressures emerging over the forecast horizon.”

Collateral Management

Draghi responded to two incidents in recent months where national central banks have admitted mistakes in evaluating collateral posted against Eurosystem loans.

“We take these incidents very, very seriously,” Draghi said. “We’ve decided to create a data quality compliance network” to address the issue.

The Spanish central bank was accused in November of applying too-low haircuts on collateral, and its French counterpart cited technical problems for a similar mistake this month.

“The way collateral is being managed and handled was decided at the beginning of the ECB,” Draghi said. “Right now we have to strengthen the governance of this process. And then we will certainly reassess the situation after that and see if the steps we have taken were sufficient.”

Youth Unemployment

Draghi said that Europe’s economy still faces a persistent level of unemployment, particularly amongst the young, that the central bank can do little about.

“We often have dual labor markets with very little protection for the young and protection for the old,” Draghi said. “Monetary policy cannot do much about that.”

Unemployment in Europe reached a record 11.8 percent in November, with at least every second young person in Spain out of work. The ECB last month predicted the 17-nation economy will shrink 0.3 percent this year instead of a forecast for 0.5 percent growth. The outlook shows inflation will average 1.6 percent, dropping to 1.4 percent in 2014 -- well below the ECB’s 2 percent price stability ceiling.

Structural reforms to restore competitiveness and tackle unemployment have to be consistently pursued by governments, Draghi said, adding that Europe’s debt crisis won’t go away without reforms enacted by political leaders.

“The point now is not to be complacent with what has taken place and relax,” Draghi said. “We start to see benefits and they don’t just come from the OMT, from ECB action,” referring to the central bank’s emergency bond program.

“They come from action by the governments.”

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