As the European Central Bank prepares to raise interest rates for the first time since 2011, policymakers hope to limit “fragmentation” in the eurozone, where borrowing costs faced by different members begin to diverge.
To this end, the ECB has set about designing a new crisis tool, the first details of which could be presented after the central bank’s meeting on Thursday (21 July).
What is fragmentation?
Lagging behind other major central banks like the US Federal Reserve and the Bank of England, the ECB is set to raise interest rates on Thursday to tackle soaring inflation.
But while the eurozone’s 19 members use the same currency, they do not share the same fiscal policy with the end effect that as interest rates rise, the borrowing costs faced by different states can begin to diverge.
More highly indebted countries in the currency club can and do end up paying a premium to investors, who perceive an added risk in any new borrowing.
This stress in bond markets is measured by the “spread” or difference between the yield for German debt — a benchmark for creditworthiness — and more debt-laden countries.
Why now?
The spread between German “Bunds” and Italian government debt has doubled from one percentage point to two in the space of a few months, spiking after the ECB’s last regular policy meeting at the beginning of June.
The peak, while not as high as in 2012 during the eurozone’s original debt crisis, prompted ECB President Christine Lagarde to call an emergency meeting.
The consequent announcement that central bank staff would finish designing a new tool to deal with bond stress cooled tensions for a while, before a fresh political crisis in Italy created renewed concern for investors.
Why is the ECB worried?
In the eyes of the ECB, fragmentation prevents all the members of the eurozone from feeling the effects of the bank’s monetary policy moves.
Rising yields in Italy can mean a business or household in Rome might have significantly higher borrowing costs than one in Berlin, even if they have the same risk profile.
For the ECB’s “monetary policy stance to be effective, we need to preserve the orderly transmission of our stance throughout the euro area”, Lagarde said at the end of June.
In other words, when the ECB steps on the economic brakes by raising interest rates, it wants the effects to be felt broadly evenly across the eurozone.
How to control spreads?
The first line of defence, already deployed by the ECB, is the “flexible” reinvestment of its bond portfolio to hoover up debt from more at-risk eurozone members and ease bond market pressure.
The second measure will be a new bond-purchasing facility that could act as a “backstop” to keep spreads in check, according to Frederik Ducrozet, head of macroeconomic research at Pictet.
In a perfect world, the ECB’s new tool would be “credible enough in order not to use it”, Ducrozet said.
This would mirror the response to the eurozone debt crisis where then ECB chief Mario Draghi’s pledge to do “whatever it takes” — and the design of an instrument to back it up — were enough to stop the panic in markets and ease the pressure.
Hurdles to overcome
Unanimous support on the ECB’s 25-member governing council would certainly lend the new tool the aura of credibility.
But some members have already expressed their reservations.
Joachim Nagel, president of the traditionally conservative German Bundesbank, said the use of a new tool could only be justified in “exceptional circumstances” and under certain conditions.
Particularly important for Nagel was some sort of “fiscal conditionality” that would stop countries seeing the new tool as a licence to spend at will.
In an attempt to head off criticism and the possibility of a legal challenge, as has been seen before in Germany, Lagarde has said the new tool would only tackle “unwarranted fragmentation”.
Achieving this was “right at the core” of the ECB’s mandate of price stability, she added.
*first published in: www.euractiv.com
By: N. Peter Kramer
