The ECB’s Solomonic solution between Germany and Italy

By Leonidas Stergiou

The European Central Bank (ECB) made use of an important tool of central banks, that of surprise. Instead of an increase in key interest rates by 0.25 of a point, as assured by the head of the ECB, Mrs. Christine Lagarde, in her speeches until recently, the increase in the end was twice as much.

Behind this sudden move, for several analysts, are the political developments in Italy, with the resignation of Draghi. Developments that in the last week took different turns, with a marginal victory in the vote of confidence, which did not help the basic problem of the Eurozone in the midst of inflationary pressures and political interest rate hikes.

Because the problem, with the change of the monetary policy, is Italy, with the huge public debt, the huge refinancings, the short-term durations and the rise of the spreads to higher levels than the Greek ones.

The decision of the ECB

There is also the technocratic interpretation of the ECB’s move to raise interest rates by 0.5 of a point, instead of the previously announced 25 basis point increase. This interpretation leads several analysts to the conclusion that we can no longer rely on the directions given by central banks for the next steps in monetary policy. There is also the opposite here. Markets, with assurances of a 0.25 basis point rate hike, had priced in the cost of money in the short and long term, while inflation remained threateningly close to 9%.

The political interpretation, however, gives more practical explanations that touch more on the macroeconomic environment and the risk of a new debt crisis, starting from the European South.

First, there were already enough voices in the ECB board calling for a rate hike of 0.5 of a point, as a smaller rise had been discounted and was insufficient to address ongoing inflationary pressures.

Second, the ECB should restore its credibility by showing grit and determination to achieve the 2% inflation target by whatever means necessary. The prevailing logic was that the announcement of the intention to raise interest rates alone caused spreads to widen and was not enough to strengthen the euro, opening the door to more imported inflation. So, since the increase would take place, let it be enough to send a strong message to the markets, convincing that the ECB will fight inflation. That is to reduce inflationary expectations.

Compromise

All this, perhaps, would not have been decided if an agreement had not been reached, at a technocratic and, above all, at a political level, on the tool for intervention in the bond markets to normalize spreads. It was a basic condition for the ECB to be free to raise interest rates and proceed with a tighter monetary policy, without the fear of a financial crisis, with the main source of risk being countries with high debt, with Italy first in line of risk.

The political compromise resulted in an intervention tool which will be able to buy bonds where there are disturbances (rising spreads), but with conditions, satisfying Germany and the “hawks” of the ECB. With the difference that these terms do not require the supervision or agreement of fiscal authorities, the Commission or the ESM. They are simply general criteria, which already exist and are based on already decided findings of various organizations. Such as, for example, a country not being in an excessive deficit regime, not being under surveillance, its debt being sustainable and showing strong macroeconomic and fiscal practices. And all this will be based on existing analyzes of the Commission, the ESM and the IMF. The ECB will simply take them into account and act autonomously. Thus, Italy, which is the main problem, meets all the above conditions.

The Italian debt

In practice, fiscal terms – even in the form of a light memorandum or surveillance – were neither desirable nor feasible. Italian debt is investment grade, unlike Greece. However, it amounts to 2.3 trillion. euros and corresponds to 151% of GDP (compared to 394 billion euros and 193% of Greece’s GDP). The average duration of Italian debt is 7.1 years, while Greek debt is 20.1 years. Also, 80% of the Greek debt is in the hands of the creditor states, compared to the Italian one, where 100% is in the hands of private investors.

Italy’s debt maturities this year amount to 346 billion euros, roughly the same as Greece’s public debt. Greece’s maturities amount to 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. On Thursday, when the ECB’s decision was announced, the spread of the 10-year Italian bonds, in relation to the yield of the corresponding German ones, fell to 244 basis points (it had reached close to 370 bps), while the Greek bonds to 234 basis points .

The effectiveness of the ECB’s maneuver, the interest rate hike and the new tool, remains to be assessed in practice, as other factors are involved, such as macroeconomic and exchange rate variables, along with geopolitical developments. For example, attention should be paid to growth, the exchange rate of the euro which determines competitiveness, but also the issues with Russian natural gas.