ECB’s crisis-fighting scheme risks being tied up in legal and political knots

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The 25 eurozone rate-setters meeting in Amsterdam last month thought they had plenty of time to finalise the European Central Bank’s plan for avoiding a bond market crisis when they started to raise rates. They were wrong.

A surge in borrowing costs for weaker southern European countries, in particular Italy, led to a divergence in yields with northern member states — a phenomenon central bankers describe as “fragmentation”. At an emergency meeting, the ECB decided to “accelerate the completion of the design of a new anti-fragmentation instrument” to counter any unwarranted sell-off in a country’s bonds.

“If the fragmentation in bond markets is unwarranted then we should be as unlimited as possible,” Pierre Wunsch, head of Belgium’s central bank and ECB governing council member, told the Financial Times. “The case to act is strong when faced with unwarranted fragmentation.”

The ECB governing council is expected to discuss the plan at a meeting in Frankfurt this week and give more details by its next meeting on July 21, when it plans to raise its deposit rate for the first time in over a decade. But it will face significant scrutiny over how the scheme will function, investors and analysts warn.

Why is the ECB doing this?

Like most major central banks — except the Bank of Japan — the ECB has stopped buying more bonds and plans to raise rates as it seeks to bring inflation down from its multi-decade highs by lifting borrowing costs and therefore cooling demand.

But the ECB has to deal with the fact that the 19 countries sharing the euro still have separate fiscal policies, meaning they can experience a growing divergence in their borrowing costs — especially when rising rates intensify anxiety over high debt levels.

The difference, or spread, between Germany’s 10-year bond yields and those of Italy has doubled from 1 percentage point a year ago to about 2 percentage points in recent weeks.

This is far below the levels reached during the 2012 sovereign debt crisis, when Italy paid almost 5 percentage points more than Germany for long-term bonds. But with Italy’s debt now even higher than in the last crisis, officials worry the country could find itself trapped in an unsustainable spiral of rising debt costs.

The ECB believes a new instrument will help ensure its monetary policy is transmitted evenly across the bloc. “We need to keep the transmission channels open, so we can’t have fragmentation,” said Mário Centeno, head of Portugal’s central bank and ECB council member. “We need a backstop.” The ECB said: “Discussions are ongoing and no decision has been taken yet.”

How will it work?

The ECB is expected to commit to buying the bonds of countries whose borrowing costs it believes are rising because of market speculation to levels beyond those warranted by economic fundamentals.

Unlike its previous schemes, which bought bonds of all countries in relation to their size, the new plan would target only the countries that most need support. The ECB may offset the inflationary impact of any bond purchases by raising a matching amount of deposits from banks.

The hard part will be deciding when to intervene. “The difficulty will be about the grey zone in between what is warranted and what is not and that is the area of moral hazard we have to navigate,” said Wunsch.

Pierre Wunsch
Pierre Wunsch, head of Belgium’s central bank, said. ‘the case to act is strong when [the ECB is] faced with unwarranted fragmentation’ © James Gekiere/BELGA MAG/AFP/Getty Images

Silvia Ardagna, an economist at Barclays, said it would be “complicated” to design the new tool, adding: “We do not expect that the ECB would unveil any specific detail on the level of yields, spreads and their respective rate of changes that would define an orderly versus a disorderly regime.”

The ECB has from this month been able to flexibly reinvest the proceeds of maturing bonds in a €1.7tn portfolio it already owns, allowing it to use German maturities to buy more Italian debt, for instance. But most analysts think such reinvestments will not be enough.

What safeguards will there be?

ECB president Christine Lagarde told its forum in Sintra, Portugal, last week that the scheme needs “sufficient safeguards to preserve the impetus of member states towards a sound fiscal policy”.

This means countries are likely to have to meet certain fiscal conditions before the ECB can buy more of their debt. Some conditions may already exist, such as the structural reforms countries agreed to carry out in return for their share of the EU’s €800bn coronavirus recovery fund. They could also be linked to the EU’s budget rules, even though these are suspended until the end of 2023.

The ECB is likely to ask the European Commission to police any conditions linked to the new instrument. “Otherwise the central bank is steering governments on fiscal policy, which is not what it wants,” said Carsten Brzeski, head of macro research at ING.

Line chart of Government debt as a % of GDP showing Debt levels on the eurozone’s periphery are still a concern

The ECB is also considering an extra requirement for countries to commit to a medium-term fiscal sustainability plan, according to officials. This could be part of the commission’s annual monitoring of national budget plans. Wunsch said: “We need countries to make an effort and come up with a credible fiscal plan.”

Any strings attached are likely to be less onerous than those for the ECB’s Outright Monetary Transactions, an earlier bond-buying programme that requires a rescue package from the European Stability Mechanism, together with tough reform requirements. The OMT has never been used and the ESM’s involvement is seen as politically toxic in southern EU countries — especially Italy.

Will the plan be legally and politically contested?

Yes, probably both. There has been a guarded response from the German and Dutch finance ministers, who insist the ECB must not encourage fiscal lassitude among member states or stray into “monetary financing” of governments, which is against the EU treaty.

The ECB’s previous purchases of sovereign bonds have been challenged repeatedly in Germany’s constitutional court and most analysts expect similar moves against its latest plan.

German central bank boss Joachim Nagel this week outlined several constraints he expected to be placed on the anti-fragmentation scheme, which he said “can be justified only in exceptional circumstances and under narrowly defined conditions”. 

Economists worry the ECB may end up being tied down by so many conditions it lacks the firepower needed to contain markets.

“If they do things halfway and don’t meet expectations,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, “they will have to do even more later, as so often happens in the euro area.”

Source: Financial Times


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