The European Central Bank is again ‘the only game in town’. The lifting of the ECB’s self-imposed 33% limit on euro area government bond purchases under its €750bn emergency programme could open the way to virtually unlimited bond buying to shore up weaker countries suffering from the pandemic.
Fragmentation of European Union fiscal efforts, and strong opposition from Rome politicians to allegedly punitive conditions on large-scale borrowing from the euro bloc’s European Stability Mechanism bail-out fund, have forced the ECB’s hand. ‘European solidarity is being maintained only by the ECB,’ says one central bank official. ‘The governments are taking a back seat, the ECB is taking action. It’s the old story. There is very strong pressure from France, Italy and Spain on the German and Dutch governments. The Germans and Dutch are resisting the pressure whereas the ECB has given in.’
In less than a fortnight, the ECB has given way in a struggle aimed at getting governments to take effective EU-wide fiscal measures to counter a severe virus-induced recession now looming. After cautiously tipping her toes in expansionary waters with a €120bn extension to asset purchases on 12 March Christine Lagarde, who took over the presidency in November from Mario Draghi, has steered the bank into a stormy sea with the last week’s programme.
A member of the governing council explains: ‘We thought that by saying, “We can’t do everything, we have our limits’”, we would put pressure on the [EU] governments to do more. This was a game of chicken, but we lost. We thought we would make our contribution, bringing some more funding through LTROs [long-term-refinancing operations], with help for smaller businesses. But no one else came up with any money and that was the reason why we had to decide the emergency buying programme last week.’
Other officials clarify that an ancillary reason for the emergency programme was liquidity shortages hitting financial markets caused by a world-wide dollar shortage in the wake of widespread turbulence.
The governing council member adds: ‘It would be good if the ECB were not the only game in town, but I’m afraid that may continue to be the case. The difference between Lagarde and Draghi is that Draghi wanted to be the only game in town, even though he said he didn’t. When Lagarde says she doesn’t want to be the only game in town, she means it.’
As clarified late on 25 March, the pandemic bond-buying will not be subject to the same constraints as previous programmes, giving the central bank considerable flexibility. Bold ECB support may offer short-term relief. Yet shortcomings in EU-wide fiscal policy – together with legal and political turbulence resulting from breaching previous ECB limits – could undermine the euro in the longer term.
Undermining dissent on a central issue for the euro area’s survival, France, Italy and Spain and six other euro area governments on 25 March urged joint European debt issuance. The group includes Belgium and Luxembourg among northern European creditor states, as well as Greece, Portugal, Ireland and Slovenia.
Germany and the Netherlands lead an opposing faction arguing that common issuance – such as for a mooted €1tn ‘coronabond’ to strengthen medical facilities and support crisis-damaged industries – would be an ineffective addendum to national borrowing. This has exposed a damaging rift on appropriate action to limit the effects of possible year-on-year peak-crisis GDP contractions of up to 20%.
The ECB move could unleash still higher purchasing volumes if Italy uses a modest ESM borrowing – with little or no conditionality – to initiate potentially unlimited preferential bond purchases under the ECB’s ‘outright monetary transaction’ programme unveiled by Draghi in 2012, but never used. However, such action would lead to considerable controversy over conditionality. ‘A combination of the ESM and OMT would have a fiscal effect for Italy but it is an illusion to think this can be done without some kind of conditionality. It’s not so much linked to the budget, it’s more linked to reforms and productivity, to provide a means of helping revive Italian growth,’ the governing council member says. As a further impediment to OMT utilisation, he cites possible legal impediments at the German constitutional court.
The ECB decision to lift the issuer limit came after initial opposition by German, Dutch and other members of the government council. Depute the virulence of the pandemic upset, the ECB’s internal unity may again be under pressure. The issuer and issuance limits were one reason why the European Court of Justice ruled that the ECB’s quantitative easing programme was not monetary financing in a challenge brought by the German constitutional court in 2018.
Another element of ECB flexibility is the lowering of the emergency programme’s minimum bond-buying maturity to 70 days, making all German debt issuance eligible for purchase. ECB buying is still meant to be conducted proportionate to the size of member states’ economies. However, the ECB now states that purchases should be in ‘a flexible manner allowing for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions’. This extends a policy first discussed in 2016, revealed in an ECB document in December 2019, under which the ECB can purchase bonds with a ‘flexible, yield contingent approach’, suspending purchases for lower-yielding bonds like Germany’s and implicitly shifting purchases disproportionately to Italian bonds.
David Marsh is Chairman of OMFIF. Danae Kyriakopoulou is Chief Economist and Director of Research at OMFIF.