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Why Europe Needs New Tools for Bond ‘Fragmentation’: QuickTake

The Euro sculpture illuminated outside the Eurotower, the former headquarters of the European Central Bank (ECB) in Frankfurt, Germany, on Tuesday, Dec. 15, 2020. ECB Supervisory Board Chairman Andrea Enria said that the ECB is enabling payment of dividends within limits. Photographer: Alex Kraus/Bloomberg
The Euro sculpture illuminated outside the Eurotower, the former headquarters of the European Central Bank (ECB) in Frankfurt, Germany, on Tuesday, Dec. 15, 2020. ECB Supervisory Board Chairman Andrea Enria said that the ECB is enabling payment of dividends within limits. Photographer: Alex Kraus/Bloomberg (Bloomberg)

The European Central Bank is trying to prevent a sovereign-debt storm with the promise of a new tool to curb market stress as it raises interest rates for the first time in a decade. The effort gained urgency after the yield on 10-year Italian bonds breached 4% in June, the highest since 2014. Investors see the renewed push to tackle so-called fragmentation as evidence that policy makers are fighting to prevent borrowing costs of euro nations from diverging excessively. That’s a dynamic that threatened to rip the euro zone apart during a crisis a decade ago.

1. What’s meant by ‘fragmentation’?

The term refers to a jump in borrowing costs for weaker euro-zone countries relative to stronger ones. While the currency bloc’s 19 economies differ by metrics like inflation, economic growth and debt, policy makers say some market moves don’t reflect these fundamentals and are too rapid. The states with the highest ratios of debt to gross domestic product -- notably Greece and Italy -- had some of the highest bond yields among major nations in June. What’s more, the difference in yield, or spread, above Germany, the continent’s benchmark, had widened. Making matters worse is a government crisis in Italy, which could test the ECB’s resolve.  

2. Why is that a recurring problem for the euro area?

While euro members share a common currency, they implement their own tax and spending policies, leading to divergences that can swell over time even with European Union limits on budget deficits. That’s a unique challenge for the ECB, which joined its peers around the world in buying government bonds to support a recovery after the 2008 global financial crisis. The EU’s founding treaties prohibit the ECB from financing member governments, and broad buying of bonds tests that idea. Germany’s Bundesbank, the central bank that provided the blueprint for the ECB, has historically spoken out about the dangers of such moves. Its president, Joachim Nagel, warned in early July that the use of a new instrument must be limited to “exceptional circumstances,” and that governments will still need incentives to reduce their debt.

3. What ‘crisis tools’ have been deployed in the past?

Most famously, there was Mario Draghi’s Outright Monetary Transactions program, a bond-buying initiative that was never actually called upon after markets took the former ECB president at his word when he vowed in 2012 to do “whatever it takes” to keep the euro intact. His promise calmed a panic touched off in 2009, after Greece came clean about its budget deficit and borrowing costs soared. That crisis led to bailouts for Greece, Ireland, Portugal and Cyprus plus a rescue of banks in Spain. More recently came the ECB’s Pandemic Emergency Purchase Program, another bond-buying push that was drawn up in a matter of days as Covid-19 swept across the continent in 2020. PEPP, as it’s known, ended up reaching about 1.7 trillion euros ($1.7 trillion) before net purchases were halted in March. 

4. What might the new tool look like? 

The new backstop -- dubbed the Transmission Protection Mechanism -- will first and foremost be a new bond-buying tool. Analysts expect it to be unlimited in nature, with some aspects left deliberately vague. So as not to upset efforts to curb record inflation, the instrument would also probably involve selling other securities in the ECB’s portfolio, according to people familiar with the matter. An alternative would be to drain the liquidity created from the system, similar to what was done at the time of the now-defunct Securities Markets Program from 2010. ECB President Christine Lagarde told euro-area finance ministers on June 16 that the tool would kick in if borrowing costs for weaker nations rise too far or too fast, according to people briefed on their discussions. 

5. What conditions might be included? 

Lagarde has said that ECB purchases under the new tool will come with “sufficient safeguards” to ensure governments keep their finances in check. A toned-down version of Draghi’s OMT program, with increased EU surveillance or further reform proposals, may be acceptable, according to Bloomberg Economics. Economists at the Brussels-based Bruegel think-tank proposed a similar structure in a paper prepared for the European Parliament that recommended officials opt for a country-specific purchase tool where EU policy makers confirm that a nation’s debt is sustainable. As the ECB moved to raise rates, those debts become a heavier burden. 

6. Is the new tool the only thing the ECB is doing? 

No. The ECB has also remodeled its pandemic-era asset-purchase program so it can use reinvestments of maturing debt more flexibly. Officials have opted against imposing strict targets for thresholds for these operations, people familiar with the matter have said. Redirecting the proceeds of core countries’ expiring debt to struggling markets may be enough to keep speculators at bay for now. 

7. What are the challenges? 

Time and politics. While the promise of a new instrument bought some respite, the ECB was under pressure to announce something concrete at its July 20-21 policy meeting. However financial market assets globally were undergoing a rapid repricing as the world’s inflationary shock worsened, suggesting more potential strain on Europe’s pressure points. At the ECB itself, meanwhile, not everyone’s equally keen to throw a lifeline to countries they deem as fiscally irresponsible, complicating agreement over any new tool.

8. What has ‘whatever it takes’ come to mean? 

The phrase signifies a pledge of ECB might of such potency that it’s sufficient to scare speculators into backing off -- as they did in the wake of Draghi’s promise. Some 10 years after he uttered those famous words, all eyes were on whether Lagarde, his successor, could pull off a similar stunt. 

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