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The ECB arms itself against bond market pessimism

Long before he was Italy’s prime minister, Mario Draghi declared that the euro was “like a bumblebee”. In 2012, the then president of the European Central Bank called it “a mystery of nature. . . it shouldn’t fly, but it does.” The economic union is only half completed, held together by political will and policy creativity. This week in Frankfurt, his successors unveiled their latest improv – one that will really matter to whoever takes over from Draghi as Italian Prime Minister.

One of the challenges of the eurozone is to conduct monetary policy in a region where financial conditions vary widely. What happens when investors worry about the sustainability of a state’s debt? These concerns can drive up local interest rates and in fact cause the central bank to lose the ability to set monetary policy in that country. This is a bigger problem when interest rates are higher – and the ECB this week raised interest rates by half a percentage point for the first time in more than a decade.

That concern is why the ECB on Thursday unveiled the so-called “Transmission Protection Instrument”, which gives the central bank the freedom to buy sovereign debt from eurozone countries where “deterioration in financing conditions [are] not justified by country-specific fundamentals”. In short, if the ECB thinks investors are panicking, it will step in to buy debt and put a floor under bond prices.

Italy, where Draghi stepped down as prime minister this week, is not the only problem, but the most pressing; 10-year borrowing costs this week were 2.3 percentage points above Germany’s, close to a recent three-year high. Italy’s debt is about 150 percent of GDP.

It is worth clarifying what all this means. The shape of the eurozone debt market will be constrained by the ECB, which will limit the difference in borrowing costs between countries. But for states likely to benefit, this process will also create a new dynamic, partly due to the terms of the program.

States from which the ECB is buying debt must comply with EU fiscal rules, have a sustainable debt trajectory and ensure that they honor all commitments they have made to access EU funds after the pandemic.

This will be of particular importance to Italy. Draghi’s government had negotiated to receive around €200 billion from the EU’s post-pandemic recovery fund, in return to make Italy more competitive and business-friendly. Rome, in short, was encouraged by the rest of the bloc to make painful reforms. Draghi said on Wednesday that to receive the next tranche of cash, worth €19 billion, Italy had 55 separate targets by the end of the year. These reforms must be supported to prevent future crises by growing Italy.

It is unclear who will form the new government after the upcoming elections, which are scheduled for September. But the 17-month Draghi government may have put in place important guardrails for what comes next – as there is a high price in EU funds for moving away from its agenda. And by linking access to the TPI with continuing these reforms, the ECB has further tightened incentives for the next government not to deviate from it – or risk a major sell-off of Italy’s debt.

But the instrument is not about Italian politics. It is mainly about making sure that the eurozone bond markets are in line with ECB policy as it raises interest rates to counter the ongoing price shocks. Pressure will mount as European states bear the cost of this inflationary slowdown. Expect more improvisation to keep the bumblebee aloft.

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