Analysis: The fault lines of the ECB bond support plan have been exposed by the political crisis in Italy

The main building of the European Central Bank (ECB) is seen at sunset in Frankfurt, Germany, January 5, 2022. REUTERS/Kai Pfaffenbach/

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  • ECB to unveil new program to limit borrowing costs next week
  • Combatting the spread in Italy may pose legal challenges
  • Conditions considered key to any intervention

FRANKFURT, July 15 (Reuters) – A government crisis in Italy is complicating a politically sensitive plan by the European Central Bank to support debt-ridden euro-zone countries in the bond market before it even begins in earnest.

In an unprecedented attempt to contain the cost of borrowing, the ECB said last month that it would buy more of a given sovereign’s bonds if its debt yields rose unjustifiably too much. Continue reading

The program, which uses proceeds from the ECB’s existing bond holdings and a new mechanism to be unveiled next week, came in response to a sudden rise in yields across southern Europe.

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The rise was most notable in Italy, mainly as investors discounted slower economic growth and the impact of higher interest rates on its €2.5 trillion debt pile. Continue reading

But the recent rise in Italian bond yields and credit spreads paid to safe-haven Germany has been more difficult to interpret as markets react to fears of a collapse of Mario Draghi’s government, whose fate is at stake. Continue reading

This puts the ECB in the awkward position of being able to determine what part of the spread widening is “unwarranted” – or abandon buying Italian bonds altogether.

This decision has legal implications, as intervening in the midst of a government crisis would provide new ammunition for those who accuse the ECB of breaking the law through its market transactions by meddling in politics.

Such criticism – along with lawsuits against a longstanding ECB asset purchase program – has been prominent in Germany.

Bundesbank President Joachim Nagel clarified his recent concerns this month, saying that determining whether or not a risk premium is justified is “virtually impossible” and that market prices should be considered fair until proven otherwise. Continue reading

“The widening in spreads is a result of a market reassessment of the fiscal outlook and the prospect of reforms. So before a new government is announced, it is difficult to say that it is unjustified,” said Dirk Schumacher, economist at Natixis.

VOLATILE SPREADS

The ECB buys bonds from Italy, Spain, Portugal and Greece with some of the proceeds it receives from maturing German, French and Dutch debt to limit spreads between the countries’ borrowing costs.

It’s also working on a new program that will allow it to buy even more bonds from southern European countries using newly minted money, which could then be offset by withdrawing liquidity via reverse auctions or certificates of deposit. Continue reading

In both cases, purchases can only be activated if the “fragmentation” between different countries, which the ECB calls financial “fragmentation”, is deemed unjustified.

When the ECB announced its plans on June 15, the closely watched spread between Italian and German 10-year bonds had reached a two-year high of 250 basis points. That helped narrow it down to 186.

It’s now back around 222 as investors weigh hopes that Draghi – Christine Lagarde’s predecessor as ECB President – will stand against the risk of snap elections, which polls suggest Italy’s far-right Brothers emerge as the strongest party could.

This also raises the question of which later increases are justified or not.

“The ECB will not and should not react to what is happening in Italy,” said Frederick Ducrozet, an economist at Pictet, adding that it could let the spread rise to 300 basis points without intervention.

STRIP ATTACHED

The new system will come with conditions aimed at thwarting new legal challenges by showing the courts that the ECB is not simply funding indebted governments.

Countries could be expected to comply with the European Commission’s economic recommendations and the conditions of the European Union’s recovery fund, and their debt could be deemed sustainable by the ECB, the Commission or the European Stability Mechanism, sources told Reuters.

Given the events in Italy, these conditions could prove crucial to make the scheme workable.

“You can say to Italy: it’s your choice, you’re either European or you’re not,” said Ducrozet.

With Europe on the cusp of recession when Russia shuts off gas this autumn, others say the ECB shouldn’t play hard.

“In the current situation, Europe cannot afford a new crisis,” said Carsten Brzeski, economist at ING.

“This means the ECB has to sound even more determined to act and it also means easier conditionality for the new instrument.”

He saw the ECB associating the new system with a country clinging to reform plans, rather than bearing the stigma of including the ESM – created as a bailout fund a decade ago.

In 2018, the ECB stayed put as Italian spreads widened following the formation of what was then seen as a populist and Eurosceptic government.

But now worries about higher interest rates and political concerns are harder to disentangle.

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Reporting by Francesco Canepa; Adaptation by John Stonestreet

Our standards: The Thomson Reuters Trust Principles.

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