On 5 May, Germany’s constitutional court decreed that the European Central Bank had exceeded its mandate in the implementation of its quantitative easing programme. In addition to the dangerous precedent of contradicting the European court of justice, this has raised market concerns about the ECB’s ability to sufficiently conduct future QE to maintain financial stability and help engineer an economic recovery.
While peripheral spreads rose and the euro weakened after the court ruling, existential worries are misplaced. The economic crisis resulting from the pandemic is massive and though the euro area’s architecture has not been reformed enough to fix the monetary union’s deficiencies, the tail risk of an Italian exit is lower than consensus estimates.
Specifically, three major developments support the prospect of a sustainable European solution for Italy and other peripheral public debt challenges. First, the crisis has worsened the fiscal profile of all European sovereigns. Even relatively optimistic forecasts by the European Commission predict Germany and the Netherlands will experience a 12-15 percentage point rise in their debt-to-GDP ratios this year. But more importantly, France is forecast to end the year with a ratio of 116%. The political consequence is that public debt management moves from a peripheral issue to a core euro area problem. Thus, any policy approach will need to help France cope, and by extension, such measures are likely to support Italy and others as well.
Second, all the enacted measures over the past decade have created an increasing stock of liabilities that would make the cost of any euro area breakup much higher for all parties. This changes the incentive structure for seeking compromises to ensure sustainability and financial stability. In other words, exposure to Italian debt prevents a Greek-style stand-off where most of the exit pains would fall to the departing country. In detail, after five years of QE and the pandemic emergency response, the ECB is likely to hold more than €500bn in Italian government bonds on its consolidated balance sheet by year-end (up from roughly €400bn pre-crisis).
Third, the Covid-19 crisis is transforming European politics, particularly in Germany. There has been a notable shift in public opinion perceiving this crisis as a shared challenge. Chancellor Angela Merkel’s government has stressed European solidarity, and the leadership race to succeed her looks increasingly favourable to Armin Laschet, prime minister of the North Rhine-Westphalia region, who has an even more constructive view of Germany’s role in Europe. Any German governmental decision in support of the ECB actions would obviate this week’s court decision, which stressed that economic and fiscal policy impacts require German governmental approval. None of this will bring about the long-desired fiscal union or debt mutualisation, but the range of policy options and the degree of fiscal transfers will certainly be greater than any time since the creation of the euro.
In the interim, the patchwork of measures already in place are quite durable. Spreads may have widened, but this does not signal severe distress. They remain much lower than during the 2011-12 sovereign debt crisis and even below the reign of the Five Star Movement government in 2018-19. Actual debt servicing costs are more muted. The 10-year yield on Italian debt stands below 2% and its five-year average. ECB bond purchases will ensure yields remain at these levels. Factoring in the estimated fiscal support of approximately €150bn from the various EU programmes (temporary support to mitigate unemployment risks in an emergency – known as SURE – the recovery fund and European Investment Bank) and a possible concessional credit line from the European Stability Mechanism worth 2% of GDP, Italy’s need to tap private sector lenders is limited despite the blowout in its deficit. Thus, there is very little immediate rollover risk and no expected spike in spreads over the course of the coming months.
In the long term, the challenges remain and the ECB’s role as a monetary financer will need to be legitimised or larger scale fiscal support will be required. The irony is that the German constitutional court, of all institutions, has implicitly suggested that the ECB actions require the approval of fiscal authorities – i.e., signalling that a de facto end to the ECB’s independence would be in line with the legal requirements. It is unclear whether the German judges imagined such an outcome.
Elliot Hentov is Head of Policy Research at State Street Global Advisors.
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