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Crisis looms if the ECB’s new tool comes up short

The writer is a senior fellow at Harvard Kennedy School and chief economist at Kroll

It has been 10 years since the President of the European Central Bank, Mario Draghi, made his famous promise to “do everything” to keep the eurozone together. How ironic that the same man is now at the helm of the country that might bring the currency union back into crisis.

Italian 10-year government bond yields skyrocketed after the ECB announced it would end its bond-buying program in July and then consider raising rates. The spread to German Bund yields, a key measure of financial stress in Europe, reached its widest since 2013. ECB officials calmed markets by holding a crisis meeting announcing that 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 its emergency meeting on 15 June, the ECB announced it will reinvest maturing bonds “flexibly” under its Pandemic Emergency Purchase (Pepp) program. But the mechanism for reinvestment is unclear. If Pepp’s reinvestments can be withheld (temporarily shrinking the ECB’s balance sheet) and then deployed in one country at once, that could be an incredibly powerful tool. But it’s unclear if this will be allowed. There are also important political constraints. I doubt the German Bundesbank would be happy to exchange Bunds with BTPs on its balance sheet.

The second existing tool is Outright Monetary Transactions (OMT). OMT, created during the 2012 debt crisis, involves the ECB buying a country’s sovereign debt on the secondary markets – as long as that country has agreed to strict terms. It has never been used, mainly because countries have made it clear that they would not agree to fiscal march orders from the European Stability Mechanism (ESM). While it still exists, it is in fact defunct.

And so the ECB’s Governing Council has instructed staff to devise a new tool to tackle 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 scope and free of conditionality while OMT is unrestricted and has strict conditionality. The new anti-fragmentation tool will fall somewhere in between.

To reassure investors, the new mechanism will have to be surprisingly large. But how big is that? And for what purpose? As fiscal policy diverges across the eurozone, government bond yield spreads should widen. How will the ECB determine which spreads are appropriate and unacceptable? If the ECB announces the spreads it targets, investors will test this.

To overcome opposition from Northern European countries concerned about moral hazard and avoid legal challenges, the anti-fragmentation instrument must have preconditions. It is clear that the conditionality of a full program under the ESM is too much. One option is to allow countries access to the anti-fragmentation tool only if they are not in a excessive deficit procedure for deficits or debt that are too high, or if they meet the milestones of the Recovery and Resilience Fund. But government bond yields can move quickly, while EDP and RRF assessments are political processes that take time.

Plus, one of the reasons Italy inspires the rushed creation of this anti-fragmentation tool is that it may not clear up this lower barrier to entry. The primary budget deficit (excluding debt servicing costs) in 2021 was just under 4 percent of gross domestic product and it has a relatively poor track record when it comes to absorbing EU funds.

Time is not on Italy’s side either. It has about €200 billion in guilt to roll over an additional EUR 305 billion later this year and next year. The weighted average maturity of the Italian government debt is approximately seven years. This compared to about 18 years for Greece. In addition, elections will be held in Italy in June 2023. Italy’s debt will look even riskier if Draghi leaves and populists maintain momentum.

In March 2020, ECB President Christine Lagarde . said declared (in) famous the central bank is “not here to close spreads. † † There are other tools for that and other actors to really tackle those problems.” That’s wrong. The other instruments are ineffective and the other actors — namely the tax authorities — are not acting. Markets are calm at the moment, but with lukewarm growth, high inflation and high deficits and debt in the eurozone, a damp squish for an anti-fragmentation tool could spark another crisis.

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