By Leonidas Stergiou
The technical services of the ECB are proceeding with a “stress test” of the scenarios for the new intervention tool in the bond markets, while at the political level a solution is being sought for the terms and wording. The tug-of-war between technical efficiency and political balances seems to result in three groups of possible of scenarios for the ECB’s new intervention tool in the bond markets The analysis of these three scenarios shows the political and technical difficulty of the undertaking which may lead the ECB to slightly delay the announcements, i.e. towards the end of the month, compared to July 21st.
Possible solutions focus on the following three scenarios:
Intervention with conditions that are or will be
This scenario envisages that the ECB will be able to intervene with bond purchases to reduce spreads in countries that are not in an excessive fiscal deficit regime. So it will be able to prop up Italian bonds where the problem is.
Another term could relate to the future, such as, for example, a reduction or zero of the general government deficit after 2024, as part of the review of fiscal rules by European governments. This presupposes political agreement, while it is not a restriction for the ECB to support Italian bonds today, as it concerns 2024.
Corresponding formalities and ways of imposing direct and specific conditions have fallen on the table (eg for the course of the Recovery Fund, etc.).
Moreover, in addition to the political implications and the risks of a financial crisis if a “memorandum” is implemented in Italy, the ECB, as an independent monetary authority, cannot impose and monitor fiscal conditions. This requires the involvement of the ESM, which is already it exists with the OMT program, which never worked. If he wanted such a tool that also absorbs the liquidity of the support so as not to fuel inflation, that already exists and could be used.
Intervention when spreads are not justified by fiscal figures
This scenario indirectly pushes for fiscal discipline, without imposing it. The ECB will be able to buy bonds to reduce the spread if it determines there is no fiscal derailment or the government takes fiscal action.
Indirectly, that is, it pressures the governments of the countries it will support to show fiscal discipline in the markets. The problem in this scenario is the criterion, i.e. when the spreads are not justified by the fiscal situation of the country.
Purchases or pre-purchases of bonds through swaps
This scenario envisages that the ECB would be able to selectively buy bonds where spreads are widening and then absorb liquidity through the deposit-taking mechanism. One way is to reduce the limit of excess liquidity that is not interest-bearing. Today, the loaned part is also accepted with a 0% interest rate. But with the rise in prime rates, the deposit rate will also rise. Therefore, the cash will be channeled back to the ECB again.
An alternative to this scenario is to exchange, for example, an Italian maturing bond with a German one, through a swap. This does not actually create new liquidity, but rather a possible loss on the balance sheet of Germany’s central bank (Buba). Because in a rising interest rate environment, the prices of the Italian bonds that will be held by the Bundesbank will fall. This, in turn, will create a loss and potentially lower dividend yield for the German government. Thus, there may be technical, political and legal issues.
At the moment, technical services are stress testing central banks’ balance sheets in order to determine the effects of such swaps on yields and interest rates. Any losses may be large given the total support from the ECB amounting to 6.5 trillion. euro (bond purchases due to pandemic).
Another alternative to the third scenario is for the ECB to invest in the Italian bond market an amount equal to the maturities of, say, the next 12 months. In practice, every bond that matures will be rolled over, with the market taking the refinancing of the debt as a certainty. This can work in conjunction with swaps as they limit the other central bank’s balance sheet damage or default risk.
The difficulty of fiscal terms
The scenario of intervention in concrete and substantive terms seems to be losing ground for technical and political reasons. In principle, such a tool exists. It is the so-called OMT (Outright Monetary Transactions), which was created in 2012, when Mario Draghi was president of the ECB, and was never used. It was then created for Greece. It provides support (bond purchases) and simultaneous absorption of liquidity through ECB. However, it is given on budgetary terms through the European Support Mechanism (ESM), i.e. a memorandum, or to countries under heightened surveillance.
The problem is Italy
Today, the problem is Italy, not Greece. Italy’s debt maturities in 2022 amount to 346 billion euros, roughly the same as Greece’s public debt, with corresponding maturities of about 20 billion (of which interest is around 12 billion euros). Italy’s central bank has announced that it will have to refinance 222 billion euros worth of bonds by the end of the year, calling the spread of 2 basis points over 10-year German bond yields excessive. Italy’s public debt amounts to 2.3 trillion. euros (151% of GDP) with an average duration of 7.2 years compared to 2.1 years for Greece (394 billion euros or 193% of GDP).
The irony is that today at its helm is Mario Draghi of OMT, which in theory could be implemented, but nobody wants it. It can be implemented because it ensures the reduction of spreads and the simultaneous absorption of liquidity that creates inflation, that is, something compatible with the existing monetary policy of rising interest rates. At the same time, it imposes fiscal discipline, which ensures the credibility of the mechanism and the agreement of the “hawks” in the ECB.
Italian elections and Germany
On the other hand, no one wants Italy, the third largest economy in the Eurozone, to enter a memorandum or light fiscal surveillance. Politically, it creates problems for Draghi himself in the run-up to elections in 2023, while it may strengthen nationalist voices. At the same time, it also brings to the surface the balances in the political scene of Germany, which still has not legislated the operation of the ESM. At the same time, Germany is politically and economically weakened, compared to 2012. The war in Ukraine, Germany’s attitude towards Russia and the energy crisis highlight problems of competitiveness and productivity, but also of political management. Even Germany’s increased defense spending signaled a new political-economic approach.
Risk of a new crisis
But also technically there is a risk of creating a new wave of financial crisis by implementing a fiscal program in an economy such as the Italian one, creating chain effects throughout the European periphery that can also be transmitted to the core of the Eurozone. The latter has a significant exposure in Italy and the rest of the south.
Opposite the OMT is the current bond purchase program (PEPP) created to absorb the pandemic crisis. Support is provided without conditions.
The middle ground
Therefore, the ECB should come up with a solution somewhere between PEPP and OMT that has conditions, but such that may not involve the ESM or the Eurogroup etc. Because the ECB, as an independent monetary authority, cannot impose and monitor fiscal conditions. Also, as the head of the ECB, Christine Lagarde, recently stated in the European Parliament, the new tool should be autonomous and flexible, that is, it should operate under the control of the Central Bank. He reminded that the OMT exists, that it is a tool, but the ECB is looking for something else as conditions have changed.
The problem of ambiguity
Therefore, describing the problem is like looking for a support tool that is given with conditions, but…unconditionally. If this becomes so apparent in the markets it will be another blow to the ECB’s credibility, following its errors in inflation forecasts. Even delaying the announcement of the new tool, i.e. after the July 21 meeting, may have a negative impact on the markets.