Why Europe needs new tools for bond ‘fragmentation’: QuickTake

Comment

The European Central Bank is trying to head off a sovereign debt storm with the promise of a new tool to reduce market stress as it raises interest rates for the first time in a decade. The effort has become urgent after the yield on Italian 10-year bonds crossed the 4% mark in June, the highest since 2014. Investors see the new pressure to fight so-called fragmentation as proof that policymakers are fighting to prevent the borrowing costs of euro countries from diverging too much. It’s a dynamic that threatened to tear the eurozone apart during a crisis a decade ago.

1. What is meant by “fragmentation”?

The term refers to an increase in borrowing costs for weaker countries in the eurozone relative to stronger countries. While the 19 economies in the currency bloc differ in metrics such as inflation, economic growth and debt, policymakers say some market moves don’t reflect those fundamentals and are too fast. States with the highest debt-to-gross domestic product ratios — notably Greece and Italy — saw some of the highest bond yields among major nations in June. In addition, the yield gap, or spread, above Germany, the continent’s benchmark, had widened. Worse still, a government crisis in Italy could test the ECB’s resolve.

2. Why is this a recurring problem for the euro zone?

As euro members share a common currency, they implement their own fiscal and spending policies, leading to divergences that can swell over time, even with European Union limits on budget deficits . This is a unique challenge for the ECB, which has joined its peers around the world in buying government bonds to support a recovery from the 2008 global financial crisis. The EU’s founding treaties prohibit the ECB to finance member governments, and the massive purchase of bonds is testing this idea. The German Bundesbank, the central bank that provided the model for the ECB, has always denounced the dangers of such measures. Its chairman, Joachim Nagel, warned in early July that the use of a new instrument must be limited to “exceptional circumstances” and that governments will still need incentives to reduce their debt.

3. What “crisis tools” have been deployed in the past?

The most famous is Mario Draghi’s Outright Monetary Transactions program, a bond-buying initiative that went unsolicited after markets took the former ECB president at his word when he pledged in 2012 to do “whatever it takes” to keep the euro intact. . His promise calmed a panic that started in 2009, after Greece unveiled its budget deficit and borrowing costs soared. This crisis led to bailouts for Greece, Ireland, Portugal and Cyprus as well as the rescue of banks in Spain. More recently came the ECB’s Pandemic Emergency Purchase Program, another bond-buying push that was crafted in days as Covid-19 swept across the continent in 2020. The PEPP, as we call it, ended up reaching around 1.7 trillion euros ($1.7). trillion) before the end of net purchases in March.

4. What could the new tool look like?

The new backstop – dubbed the Transmission Protection Mechanism – will primarily be a new bond-buying tool. Analysts expect it to be open-ended in nature, with some aspects left deliberately vague. In order not to upset efforts to contain record inflation, the instrument would also likely be to sell other securities from the ECB’s portfolio, according to people familiar with the matter. An alternative would be to drain the liquidity created by the system, as was done under the old securities markets program from 2010. ECB President Christine Lagarde told ministers of eurozone finances on June 16 that the tool would kick in if borrowing costs for weaker countries rise too much or too fast, according to people briefed on their discussions.

5. What conditions could be included?

Lagarde said ECB purchases under the new tool would come with “sufficient safeguards” to ensure governments have their finances under control. A watered down version of Draghi’s OMT program, with increased EU surveillance or new reform proposals, could be acceptable, according to Bloomberg Economics. Economists at the Brussels-based Bruegel think tank proposed a similar structure in a paper prepared for the European Parliament that recommended officials opt for a country-specific buying tool where EU policymakers confirmed that a country’s debt was sustainable. As the ECB has decided to raise rates, these debts become a heavier burden.

6. Is the new tool the only thing the ECB is doing?

No. The ECB has also reshaped its pandemic-era asset purchase program so that it can use reinvestments of maturing debt more flexibly. Officials chose not to impose strict threshold targets for such operations, people familiar with the matter said. Redirecting proceeds of expiring debt from core countries to troubled markets might be enough to keep speculators at bay for now.

7. What are the challenges?

Time and politics. While the promise of a new instrument offered some breathing room, the ECB was under pressure to announce something concrete at its July 20-21 policy meeting. However, financial market assets globally were undergoing rapid revaluation as the global inflationary shock worsened, suggesting greater potential stress on pressure points in Europe. At the ECB itself, meanwhile, not everyone is equally keen to throw a lifeline at countries they deem fiscally irresponsible, making it harder to agree on any new tools.

8. What has ‘no matter what’ come to mean?

The phrase signifies an ECB power pledge of such power that it is enough to scare speculators into backing down – as they did in the wake of Draghi’s pledge. Some 10 years after he uttered those famous words, all eyes were on whether Lagarde, his successor, could pull off a similar stunt.

More stories like this are available at bloomberg.com