ECB must act quickly to avoid further debt crisis

The European Central Bank (ECB) held an emergency meeting today and announced that it will “…accelerate the completion of the design of a new anti-fragmentation instrument…”.

This follows a poor market reaction to last week’s Governing Council monetary policy meeting (see: ECB faces challenge to avoid sovereign debt crisis).

The ECB finds itself in an uncomfortable and unstable situation. It needs to raise interest rates, but at the same time shield the periphery from excessively rising borrowing costs which will eventually worsen their public finances.

New policy tool key

Concerns over the indebtedness of peripheral governments such as Italy have led to a rise in the cost of borrowing for such governments compared to core countries like Germany.

This has in the past triggered debt crises, which the ECB is attempting to avoid as it embarks on a path of tightening monetary policy.

At today’s meeting the ECB re-affirmed its plan set out last week, to use its holding of assets under the pandemic emergency purchase programme (PEPP) to stop spreads widening further.

This relies on capital being freed up from maturing assets, before they are “re-invested” in peripheral government bonds.

Azad Zangana, Senior European Economist and Strategist, says:

“We know that the total size of the PEPP is about €1.7 trillion, though the average maturity of the assets is just over seven and a half years.

"The ECB is not sharing information about exactly which assets are held, and as a result, there is no indication of how much of the fund will be available for the ECB to use in the near-term.

“In any case, the PEPP is too limited to be an effective tool to stop the loss in confidence the market. A new promised policy tool, possibly in the shape of a large new fund would be helpful, but the ECB is likely to face significant legal challenges.

“The ECB is not meant to be taking part in “monetary financing”, which involves using monetary policy to effectively subsidise government spending.

“Despite its efforts to disguise the market’s concerns over the solvency of some countries as being related to the pandemic, it will have to be far more creative in its efforts.

“The argument the ECB has used in the past is that “fragmentation”, referred to by professional investors as “selection” or “discrimination”, could cause a debt crisis. This in turn would create a deflationary environment through a potential recession.

“However, with inflation at multi-decade highs, and the ECB attempting to raise interest rates in coming months, using deflation risks as an argument lacks credibility.

“Moreover, the introduction of the PEPP in response to the pandemic made sense at the time, but there is no evidence that the response by governments during this period has worsened the market’s perception of peripheral markets relative to the period beforehand.

“A combination of mismanagement of public finances and economies is to blame, and under current laws, the ECB should not be using its tools to subsidies these governments, nor punish better performing governments (through asset sales) for their more prudent policies.

“Yet, dovish commentators will argue that without a fiscal union, the ECB must be the lender of last resort to these governments, or risk them leaving the currency union.

“In this regard, Italy posses a major risk to the monetary union. (see: Are Italy’s days in the eurozone numbered?)

“So far, the ECB’s announcement is working in that spreads have narrowed after the announcement. Now it has to deliver quickly on its promise of a new, large and legally viable tool if another debt crisis is to be avoided.”

James Ringer, Fixed Income Portfolio Manager, says: “Today’s announcement is a step in the right direction but falls short of some expectations for an immediate implementation of an anti-fragmentation tool.

“The ECB has referenced using PEPP reinvestments to direct purchases towards one country over another many times in the past and this was again confirmed in Schnabel’s speech last night so that is nothing new.

“What is new, however, is the mention of the new anti-fragmentation instrument but this still needs to be finalised before it can be approved by the Governing Council.

“In short, it appears peripheral spreads and all-in yields had reached the point at which the ECB needed to reaffirm its commitment to supporting those markets. However, the reinvestment plan is nothing new and it remains to be seen how quickly the anti-fragmentation instrument can be rolled out.

“We expect today's news to provide temporary relief and ultimately cap where BTP-Bund spreads can get to but we think the market will continue to challenge the ECB and push those spreads back towards to recent range highs.”