The writer is a senior fellow at Harvard Kennedy School and chief economist at Kroll
It has been 10 years since then European Central Bank president Mario Draghi made his famous promise to do “whatever it takes” to hold the eurozone together. How ironic that the same man is now at the helm of the country that might just bring the currency union back into crisis.
Italian 10-year government bond yields jumped after the ECB announced it would end its bond-buying programme by July, and then consider raising interest rates. The spread to German Bund yields, a chief measure of financial stress in Europe, reached its widest since 2013. ECB officials calmed markets by holding a crisis meeting to announce they will create an anti-fragmentation tool that works better than the two it already has. Unfortunately for Italy, and the eurozone, the third time may not be the charm.
At the June 15 emergency meeting, the ECB announced it will reinvest maturing bonds “flexibly” under its pandemic emergency purchase programme (Pepp). But the mechanism for reinvestment is unclear. If Pepp reinvestments can be withheld (shrinking the ECB’s balance sheet temporarily) and then deployed in a single country all at once, it could be an incredibly powerful tool. But it’s unclear this will be allowed. There are significant political constraints as well. I doubt the German Bundesbank would be happy to swap Bunds with BTPs on its balance sheet.
The second existing tool is Outright Monetary Transactions (OMT). Created during the 2012 debt crisis, OMT involves the ECB buying a country’s sovereign debt in the secondary markets — as long as that country has agreed to strict conditionality. It has never been used, largely because countries have made it clear they would not agree to take fiscal marching orders from the European Stability Mechanism (ESM). While it still exists, it is in effect defunct.
And so the ECB governing council has tasked staff with devising a new tool to address fragmentation. They hope to announce it at the next policy meeting on July 21. I fear it will come up short. The Pepp reinvestment scheme is limited in size and free from conditionality, while OMT is unlimited and has strict conditionality. The new anti-fragmentation tool will fall somewhere in between.
To reassure investors, the new mechanism will need to be surprisingly large. But how large is that? And to what end? As fiscal policies diverge in the eurozone, spreads between government bond yields should widen. How will the ECB define what spreads are appropriate versus unacceptable? If the ECB announces the spreads it is targeting, investors will test it.
To overcome opposition from northern European countries concerned about moral hazard and avoid legal challenges, the anti-fragmentation tool must have conditions. Clearly the conditionality of a full programme under the ESM is too much. One option is only to allow countries to access the anti-fragmentation tool if they are not in an excessive deficit procedure for deficits or debts that are too high, or if they meet their Recovery and Resilience fund milestones. But government bond yields can move swiftly, while EDP and RRF reviews are political processes that take time.
What’s more, one reason Italy is inspiring the hurried creation of this anti-fragmentation tool is that it might not clear this lower bar for participation. Its primary budget deficit (not including debt servicing costs) was just under 4 per cent of gross domestic product in 2021 and it has a relatively poor record when it comes to absorbing EU funds.
Time is also not on Italy’s side. It has about €200bn in debt to roll over later this year and an additional €305bn next year. The average weighted maturity of Italian government debt is roughly seven years. This compares with about 18 years for Greece. Furthermore, Italy is due to hold an election by June 2023. Italian debt will seem even riskier if Draghi exits and populists maintain momentum.
In March 2020, ECB president Christine Lagarde (in)famously stated the central bank is “not here to close spreads . . . There are other tools for that and other actors to actually deal with those issues.” That is wrong. The other tools are ineffective and the other actors — namely fiscal authorities — are not stepping up. Markets are calm at the moment, but with tepid growth, high inflation and high deficits and debt burdens in the eurozone, a damp squib for an anti-fragmentation tool could spark another crisis.