ECB’s transmission protection instrument may lead to further crises

Reminiscences of Black Wednesday

In the afternoon of 16 September 1992, I took a cab from Goldman Sachs’ European headquarters in London to Heathrow Airport to catch a plane to Frankfurt. When we passed Buckingham Palace, my phone rang.

A journalist from the German financial daily Börsenzeitung asked me whether I expected the British authorities to succeed in defending the exchange rate of the pound in the exchange rate mechanism of the European monetary system. The pound had joined this mechanism only two years earlier and had come under heavy selling pressure against the deutsche mark. With Chancellor of the Exchequer Norman Lamont’s pledge to do ‘whatever is necessary’ to defend the pound still ringing in my ears, I said the authorities would fend off the speculators.

When I drove to work early the following day, I heard on the radio that the pound had dropped out of the ERM. The decision had been taken in the evening. Upon arrival in the office, I found a copy of Börsenzeitung on my desk. The front page was devoted to the ‘battle for the pound’ with a quote from myself placed prominently in the article: ‘Mayer expects the pound to stay firm.’ Thanks to an early editorial deadline of the paper, this was not the finest day in my career.

Perhaps one needs to have lived through the battle of the pound, which led to more battles for other currencies, to remain unconvinced of the latest invention of the European Central Bank to prevent market forces from blowing up economic and monetary union, the successor to the European monetary system. The ECB’s transmission protection instrument adds another element to the central bank’s alphabet soup of monetary policy instruments.

The TPI reminds me of the switch-off device for exhaust gas cleaning in combustion engines. The purification is automatically disabled at certain air temperatures. With the TPI, market forces can be switched off by the ECB through intervention if the interest rate differential of highly indebted euro countries to German government bonds exceeds a certain limit, which the ECB will probably keep secret. The defeat device for the exhaust gas purification system worked technically perfectly and only caused offence when it was discovered. I am not so sure about the TPI.

The reason is that this instrument has worrisome similarities with the ERM, where the chaining together of exchange rates of structurally different European Union countries led to recurring crises, of which Black Wednesday was only one of many. Time and again, speculators sold forward what they saw as overvalued currencies against the D-mark. And again and again the central banks concerned tried to defend their currencies, which were under pressure, by raising interest rates – sometimes to extreme levels. Since this was poison for the economy, they could not hold out for long, and the speculators won.

In contrast to the ERM, the intervention limits set by the ECB for the TPI in the bond market are unknown. What is clear, however, is that the spreads (interest rate differences to bunds) must not become too large. Since 2018, the ECB has seemed to want to keep the Italian spread well below three percentage points. Speculators could therefore predict that a forward sale of Italian 10-year government bonds against bunds would not cost more than 3% on an annual basis. That is peanuts compared to the penalty interest rates in the ERM, which were temporarily set at annual rates of 15% on Black Wednesday and even 500% to defend the Swedish krona. So nowadays it seems cheap to bet on Italy’s exit from EMU if Italian politics descends into chaos after the elections on 25 September.

The TPI is one of several instruments to counter fragmentation of the euro area (others are outright monetary transactions and ‘flexible reinvestment’ of maturing bonds acquired under the pandemic emergency purchase programme). But fragmentation of what? If the objective is to ensure the equal transmission of monetary policy, the focus should be on the money market, where monetary policy develops its effects. But the TPI aims at government securities ‘with a remaining maturity of between one and 10 years.’ This raises the strong suspicion that the TPI is in fact an under-cover instrument to provide monetary financing to needy governments.

The activation of the TPI is linked to the condition that the country under pressure does not suffer from economic imbalances and distortions. But, if this is the case, it would be very surprising if the market were to widen the spread. Activating the TPI to limit spreads would only be possible if market participants behaved completely irrationally. However, it is much more likely that market participants sell bonds for good reasons. Then the ECB can only activate the TPI if it disregards the conditions specifically set for it. One may assume that the ECB will not shy away from this if it is politically opportune.

Most likely, national central banks will buy the bonds of their own governments when TPI is activated to control spreads, like they did in the public sector purchase programme. Conventional wisdom has it that they therefore assume the investment risk. But this is only seemingly true. In reality, the sellers of the bonds transfer the cash they receive to the safe haven country, i.e. Germany. In turn, Germany gets a claim on the Eurosystem in the interbank payment system, Target-2, and Germany ends up assuming the largest part of the EMU break-up risk.

Figure 1. Italian government debt held by banks and central bank

Source: Banca d’Italia and ECB

Like the ERM, the TPI is therefore likely to reach a breaking point if the flight from risky bonds becomes massive. For example, speculative forward sales of Italian government bonds could lead to panic among the holders of these bonds. If they send the sales proceeds to Germany, the balances of Target-2 will explode. Already today, Italy owes over €600bn in this system, while Germany has claims amounting to €1.2tn (Figure 1). Bond purchases by the Banca d’Italia under the ECB’s asset purchase programmes were the main reason for the increase in Italy’s Target-2 liabilities in recent years.

Figure 2. Target-2 balances in the Eurosystem

Source: ECB

Of the €2.8tn Italian public debt, €740bn is already on the balance sheet of the Eurosystem, with almost all held by the Banca d’Italia. If the Banca d’Italia had to buy up that much again, Italy’s Target-2 liabilities could rise well above the trillion threshold and Germany’s claims could exceed €2tn (Figure 2). The share of Target-2 claims in Germany’s net foreign assets could rise from around 46% today to almost 100%. In other words, almost all of Germany’s net foreign assets – and not just less than half as today – could disappear if EMU broke apart.

In the ERM crisis, the governments under pressure finally pulled the ripcord. Today that would fall to Germany if its financial risk exposure to EMU went out of control. But the Berlin government will be more likely to close its eyes and pray.

Thomas Mayer is Founding Director of the Flossbach von Storch Research Institute.

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