The 25 euro zone rate setters meeting in Amsterdam last month felt they had plenty of time to finalize the European Central Bank’s plan to avert a bond market crisis when they began to raise rates. They were wrong.

A spike in borrowing costs for weaker southern European countries, particularly Italy, has caused yields to diverge with northern member states – a phenomenon central bankers call ‘fragmentation’ . In an emergency meeting, the ECB decided to “accelerate the completion of the design of a new anti-fragmentation instrument” to counter any unjustified sale of a country’s bonds.

“If the fragmentation of bond markets is unwarranted, we should be as unrestricted as possible,” Pierre Wunsch, head of Belgium’s central bank and member of the ECB’s governing council, told the Financial Times. “The case for action is strong in the face of unwarranted fragmentation.”

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

Why is the ECB doing this?

Like most major central banks – with the exception of 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 peaks of several decades by increasing borrowing costs and thus cooling demand.

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

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

That’s well below levels reached during the 2012 sovereign debt crisis, when Italy paid nearly 5 percentage points more than Germany for long-term bonds. But with Italy’s debt now even higher than during the last crisis, officials fear the country could be trapped in an unsustainable spiral of rising debt costs.

The ECB believes that a new instrument will help ensure that its monetary policy is transmitted evenly across the bloc. “We have to keep the transmission channels open, in order to avoid fragmentation,” said Mário Centeno, head of Portugal’s central bank and member of the ECB council. “We need a safety net.” The ECB said: “Discussions are ongoing and no decision has yet been taken.”

How will this work?

The ECB should commit to buying the bonds of countries whose borrowing costs it believes are rising due to market speculation to levels above those warranted by economic fundamentals.

Unlike its previous programs, which bought bonds from all countries based on their size, the new plan would only target countries that need support the most. The ECB can offset the inflationary impact of any bond purchase by raising an equivalent amount of deposits from banks.

The hardest part will be deciding when to intervene. “The difficulty will be in the gray area between what is justified and what is not and that is the area of ​​moral hazard that we have to navigate,” Wunsch said.

Pierre Wunsch
Pierre Wunsch, head of the Central Bank of Belgium, said. ‘the case for acting is strong when [the ECB is] in the face of unjustified fragmentation’ © James Gekiere/BELGA MAG/AFP/Getty Images

Silvia Ardagna, economist at Barclays, said it would be “complicated” to design the new tool, adding: “We do not expect the ECB to release specific detail on the level of yields, spreads and their rate respective variation that would define an ordered regime as opposed to a disordered regime.

The ECB was able from this month to flexibly reinvest proceeds from maturing bonds into a €1.7bn portfolio it already holds, allowing it to use German maturities to buy more of Italian debt, for example. But most analysts believe that these reinvestments will not be enough.

What guarantees will there be?

ECB President Christine Lagarde said last week at her forum in Sintra, Portugal, that the regime needed “sufficient guarantees to preserve member states’ momentum towards sound fiscal policy.”

This means that countries will likely 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 have agreed to carry out in return for their share of the EU’s €800 billion coronavirus recovery fund. They could also be linked to EU fiscal rules, even if these are suspended until the end of 2023.

The ECB is likely to ask the European Commission to check all the conditions linked to the new instrument. “Otherwise the central bank is directing governments on fiscal policy, which is not what they want,” said Carsten Brzeski, head of macro research at ING.

Line chart of government debt as a % of GDP showing that debt levels in the eurozone periphery are still a concern

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

Any conditions attached are likely to be less onerous than those of the ECB’s Outright Money Transactions, a previous bond-buying program that requires a bailout from the European Stability Mechanism, as well as tough reform requirements. The OMT has never been used and the involvement of the ESM is seen as politically toxic in southern EU countries, especially Italy.

Will the plan be legally and politically challenged?

Yes, probably both. There has been a cautious response from the German and Dutch finance ministers, who insist that the ECB must not encourage fiscal fatigue among member states or stray into the “monetary financing” of governments, which is contrary to the EU Treaty.

Previous sovereign bond purchases by the ECB have been repeatedly challenged in Germany’s Constitutional Court and most analysts expect similar action against its latest plan.

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

Economists fear the ECB could end up being tied down by so many conditions that it lacks the firepower to rein in 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 often happens in the eurozone.” .

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