ECB needs a formidable tool against fragmentation

Safety net: People walking in front of a euro sign in Frankfurt, Germany, as the ECB headquarters can be seen in the background. The challenge facing policy makers is not letting the financing costs of the most indebted euro members soar into non-viable territory. — AFP

JOACHIM Nagel, the head of the German Bundesbank, is sabotaging European Central Bank (ECB) President Christine Lagarde’s plans for a comprehensive safety net to prevent yields of peripheral European countries from blowing out.

In a coruscating address this week, he argued that it’s “virtually impossible” to determine whether a widened spread above benchmark German levels is justified, setting the scene for yet another brutal fight among policy makers that risks sparking a summer of discontent in the bond market.

As surging inflation ends the era of negative rates and quantitative easing in the eurozone, a glaring hole in the bloc’s defences has been revealed.

When Italian 10-year borrowing costs spiked above 4% in mid-June, the ECB was forced to hold an emergency meeting to soothe markets.

Its pledge to “accelerate the completion of the design of a new anti-fragmentation instrument” has worked as a stop-gap; Nagel’s speech, though, suggests nothing is settled yet.

His hardline approach risks leaving economically weaker euro nations, notably Italy and Greece, at the mercy of bond traders if markets start to doubt the ECB’s commitment to counter any sudden spike in sovereign funding costs.

It’s a back-to-the future moment that makes Lagarde’s already difficult job balancing the interests of the 19 countries using the euro that much more strenuous.

The euro is seriously unimpressed, weakening to a 20-year low against the dollar and close to breaching parity.

For now, the bond market has been more sanguine.

Italian yields are about a percentage-point lower since the ECB’s emergency meeting, but that echoes declines in German and US yields in the same time frame. There’s no room for complacency.

The challenge facing policy makers is not letting the financing costs of the most indebted euro members soar into non-viable territory.

How high is too high? Italy’s central bank governor Ignacio Visco said in mid-June that the spread between Italian and German 10-year debt should be fewer than 150 basis points based on economic fundamentals – and certainly shouldn’t exceed 200 basis points.

The outline of a so-called anti-fragmentation tool, which will be called the Transmission Protection Mechanism, is expected to be unveiled at the next ECB governing council meeting on July 21. But hopes for a “whatever it takes” bazooka to eliminate the threat of unsustainably high Italian or Greek yields look forlorn.

As I wrote last month, a sufficiently potent backstop need never be used.

The best example is the outright monetary transactions programme that former ECB President Mario Draghi heralded in 2012 to get a grip on violent spikes in peripheral nation bond yields, which has not been triggered to this day.

French central bank head Francois Villeroy De Galhau remains optimistic, telling Les Echos that “it is probable that the existence alone of this instrument allowing fast and massive intervention if needed is sufficient, without needing to activate it.”

The scale of the program will be key; as Olivier Blanchard, the former chief economist of the International Monetary Fund, said on Twitter on Wednesday, size matters.

For the head of the German central bank to question the concept of capping yields is genuinely unhelpful.

The history of the ECB is littered with challenges in the German constitutional court, and indeed resignations of Bundesbank members.

The illegality of cross-subsidization remains an obstacle, with richer northern European states wary of bailing out their highly indebted southern neighbours.

It’s an inherent flaw in the construct of the euro, an economic and monetary union without interwoven fiscal or banking pacts.

It won’t reassure Germany that French finance minister Bruno Le Maire said said in a Financial Times interview this week that European Union debt rules are “obsolete” and should be rethought.

Former Italian Premier Enrico Letta warned earlier this week about the need for euro unity.

“The response has to be common,” he said.

“The risk is that leaders turn a blind eye until it’s too late.”

It’s bad enough that the central bank has left it so late to address the risk of fragmentation.

If Nagel gets his way, the program could end up neutered and ineffective.

So far the ECB has trailed deploying an already existing flexibility, reinvesting its existing portfolio as bonds mature so that, for example, the proceeds of a redeemed German bond could be spent on Italian debt.

For the pandemic emergency purchase program, this amounts to about €10bil (RM45bil) per month, far below its regular monthly purchases of €40bil (RM180bil) earlier this year, although extending it to the full asset purchase programme would boost that firepower.

Still, if market stresses occur when redemption monies are insufficient to hold back the tide, bond traders will smell blood.

The irony for Germany and other hawkish ECB members is that, as the bond markets are swiftly pricing in, the less credible the bond support mechanism turns out to be, the fewer interest-rate hikes will be possible.

To successfully curb consumer prices after years of wanton stimulus, the ECB needs to increase borrowing costs, but it cannot do that if the unity of the eurozone is at stake.

Rate hikes and combating inflation, or fiddling while Rome burns? Your call, Germany. — Bloomberg

Marcus Ashworth writes for Bloomberg. The views expressed here are the writer’s own.