Why the ECB needs new tools for bond ‘fragmentation’
1. What is meant by “fragmentation”?
The term refers to what officials see as an unwarranted jump in bond yields from weaker eurozone governments relative to stronger ones. While the 19 economies in the currency bloc differ in metrics such as inflation, growth and debt, policymakers say some market moves don’t reflect these fundamentals and are too fast. Member states with the highest ratio of government borrowing to gross domestic product – notably Greece and Italy – were also those among the major nations with the highest 10-year bond yields in mid-June, both far superior to those of Germany, the mainland country. reference.
2. Why is this a recurring problem for the euro zone?
While members share a common currency, they implement their own fiscal policy, leading to divergences that can swell over time, even with European Union limits on budget deficits. The EU’s founding treaties prohibit the ECB from financing governments, but the large-scale purchase of government bonds is testing that idea. The German Bundesbank, which provided the model for the ECB, has historically been particularly outspoken against such a tool. The argument: these measures reduce the incentives for nations to stop overspending and make their economies more competitive.
3. What “crisis tools” have been deployed in the past?
The most famous is Mario Draghi’s Outright Monetary Transactions program, a bond-buying initiative that went unsolicited after markets took the former ECB president at his word when he pledged in 2012 to do “whatever it takes” to keep the euro intact. . Most recently, the Pandemic Emergency Purchase Program, another bond-buying push that was crafted in days as Covid-19 swept across the continent in 2020. The PEPP, as is known, has ended up reaching around 1.7 trillion euros ($1.8 trillion). ) before the end of net purchases in March.
4. What could the new tool look like?
It would be first and foremost to buy public debt. But, in order not to upset efforts to contain record inflation, the instrument would probably be to sell other securities from the ECB’s portfolio, according to people familiar with the matter. An alternative would be to drain the liquidity created by the system, as was done under the old securities markets program from 2010. ECB President Christine Lagarde told ministers of eurozone finances on June 16 that the tool would kick in if borrowing costs for weaker countries rise too much or too fast, according to people briefed on their discussions. His comments helped reduce Italy’s 10-year yield premium over German bonds.
5. Will the ECB impose conditions before starting to buy?
ECB purchases under the new tool are unlikely to come with strings attached to ensure they land on fruitful ground. A watered down version of Draghi’s OMT program, with increased EU surveillance or new reform proposals, could be acceptable, according to Bloomberg Economics. Economists at the Brussels-based think tank Bruegel proposed a similar structure in a paper prepared for the European Parliament that recommended officials opt for a country-specific buying tool where EU policymakers confirmed the sustainability of a country’s debt.
6. Is the new tool the only thing the ECB is doing?
No. The ECB has also reshaped its pandemic-era asset purchase program so that it can use reinvestments of maturing debt more flexibly. And it could preload them, allowing it to buy new bonds before older securities mature. Redirecting proceeds of expiring debt from core countries to troubled markets might be enough to keep speculators at bay for now.
7. What are the challenges?
Time and politics. While the promise of a new instrument has bought some breathing room, the ECB is now under pressure to announce something concrete at its July 20-21 policy meeting. Assets globally, however, are experiencing rapid revaluation as the global inflationary shock deepens, suggesting greater potential strain on pressure points in Europe. At the ECB itself, meanwhile, not everyone is equally keen to throw a lifeline at countries they deem fiscally irresponsible, making it harder to agree on any new tools.
8. What has “no matter what” come to mean?
The phrase signifies an ECB power pledge of such power that it is enough to scare speculators into backing down – as they did in the wake of Draghi’s pledge. Some 10 years after he uttered those famous words, all eyes will be on the ability of Lagarde, his successor, to pull off a similar stunt.
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