Bra-de-fer between the ECB and governments on the bond market intervention tool

By Leonidas Stergiou

Discussions on the European Central Bank’s (ECB) new tool to intervene in bond spreads began in Frankfurt late last week, with results so poor that some sources with knowledge of developments doubt it will be ready by the 21st. July, i.e. until the next meeting, as announced.

The debate will continue in the coming days, as the ECB’s reflection and messages to governments on fiscal rules and fiscal imbalances make a stop at the Eurogroup and ECOFIN today, Monday, and tomorrow, Tuesday. The majority of the members of the ECB and its technocrats respond to the “hawks” that the jump in bond spreads of countries with high public debt is a problem of fiscal imbalances and the lack of a unified fiscal policy that for 10 years had been hidden under negative interest rates.

Giannis Stournaras

The problem of the imperfect fiscal union was also touched upon by the Greek central banker, Mr. Giannis Stournaras, speaking on Bloomberg TV, who, at the same time, expressed optimism for the creation of a tool, which will be so powerful and convincing in the markets that it will never be used . He also appeared optimistic about the timing of the agreement and the finalization of the details of the new tool, as there is progress in discussions. “If we convince the markets that this is a very powerful tool, then we might not need it. We’ll have it on the shelf. That’s the good scenario,” Stournaras said in an interview.

The two difficulties

The disagreements focus on two crucial points. First, the criteria that will activate the new tool. Second, the terms under which bond market support will be granted.

The scenarios and solutions at the technical level are almost infinite. In politics, however, limited. The problem is that the ECB as a monetary authority cannot impose nor assess and monitor fiscal conditions. This is the job and responsibility of governments and Brussels.

If there is a common instrument with fiscal and monetary criteria, then we go back to the already existing OMT which has been in place since 2012 and has never been used. It requires a memorandum or increased surveillance, while providing liquidity absorption (from the bond markets so that inflationary pressures are not created).

But today the problem is Italy, not Greece. And no one wants a memorandum to be implemented in Italy, for political and financial reasons. If there are no conditions, then the current PEPP scheme is used. The “hawks” of the ECB and the Eurozone are insisting on an intervention mechanism with conditions so that it is not considered state financing and does not cause moral hazards and interventions by constitutional courts.

Monetary criteria only

The ECB presents the technical solutions it can use to smooth bond markets using monetary criteria. At the same time, it sends the message to governments that the new tool aims to limit sharp revaluations in spreads that will affect the effectiveness of monetary policy by raising interest rates to control inflation.

Fiscal imbalances

The rise in interest rates and the end of the bond market brought to the surface fiscal imbalances and the problem of the lack of a single fiscal policy. Perhaps, it is not by chance that the publication of a study by the ECB concludes that if there was a single fiscal policy, which would work according to the standards of the Recovery Fund, then the latest crises – even the financial crisis of 2008 – would have been milder and some may have they were almost overcome.

In the discussions, the ECB states that on the one hand it is being blamed for being slow to raise interest rates and on the other hand it is being asked to intervene to correct the spreads that are the result of fiscal imbalances. But the ECB cannot impose or monitor fiscal conditions. This is a problem and a question for the fiscal authorities, i.e. governments.

In other words, the ECB can intervene, e.g. with bond purchases or with swaps, where spreads create financing problems and become a deterrent to rising interest rates. And this to the extent that spreads increase as a result of the change in monetary policy, not due to fiscal policy. Controlling fiscal policy is the job of governments and Brussels.

Suggested solutions

In this context, technical groups and members of the ECB have proposed some solutions, which can bridge the differences, such as:

– Ad hoc decisions even for the investment tier. ECB intervention decisions should be easy, flexible, efficient and selective based on the conditions and problems faced by each market. Members of the ECB have even proposed the abolition of the investment grade criterion for the purchase of bonds. Such a move does not concern only Greece. It also concerns Italy, which is the main problem today and which has an investment grade. According to the rationale, debt sustainability risk can lead to a loss of investment grade, and all this will be priced in by an increase in the spread. If markets and rating agencies know that even if investment grade is lost, the government will be financed by ECB intervention, then the risk premium (spread) is limited (along with the possibility of a downgrade).

– Monetary criteria. Clear wording on selective interventions only where and to the extent that spreads increase due to a change in monetary policy and which may prevent further increases to control inflation. That is, the criterion will be monetary (if spreads increase so much that Italy cannot, for example, refinance its debt, then how will the ECB raise interest rates further) and not fiscal. In addition, it can increase the deposit acceptance rate or use swaps to absorb liquidity from the markets (sterilisation).

– Fiscal criteria-Eurogroup. The ECB may take into account reports on fiscal progress, fiscal imbalances or agreements on fiscal rules from 2023, which take place in Brussels. For example, the budget controls and fiscal guidelines for 2023 which are on Monday’s Eurogroup agenda. It is also an opportunity to press for a revision of the fiscal rules. But the decision and evaluation will remain in Brussels. For example, the criterion can be adopted for support in a country that is not in an excessive deficit process. This, however, will be judged by the Commission. As long as the latter has not put an economy in this regime, the ECB can intervene. Brussels can set other conditions, such as the course of the Recovery Fund, the deficit of the general government, etc., but the ECB cannot.

What has been agreed so far?

The name, perhaps temporary, was found: Transmission Protection Mechanism.

Its goal was agreed: To limit the rise in spreads in bond markets by hampering the effectiveness of monetary policy that moves to raise interest rates to control inflation.

The condition of not creating inflation, with a parallel purchase of bonds and absorption of liquidity by the ECB, seems to have been accepted.

The toolbox is technically rich, with the PEPP bond programme, a huge stock of liquidity and bonds on the ECB’s balance sheet and modern financial tools.

It remains to agree the criteria that will activate the new tool of the ECB and the conditions under which the support will be granted, obviously, to countries with high public debt. And in this period, the problem is Italy, because of the high refinancings during the year and the short maturities of the Italian debt.