The European Central Bank’s extended reinvestment of bonds acquired under its 2020 pandemic emergency purchase programme is muddying an important debate on reforming Europe’s fiscal rules. The ECB’s declared policy of continuing PEPP reinvestment until at least the end of 2024 is already controversial, given that the pandemic ended more than a year ago and the ECB’s chief priority now is combating inflation.
But there is another key reason for questioning the soundness of the ECB’s PEPP approach. The euro area’s interest rate structure plays a key role in the new debt sustainability framework at the centre of the European Union’s refashioned stability and growth pact.
However, PEPP reinvestments, by distorting euro area capital market interest rates, appear to be obscuring the true cost of public debt in the euro periphery. In the interest of euro area stability, the ECB has clear reasons to bring about a precisely focused debate on Europe’s fiscal rules. So that this can happen, PEPP reinvestments should end far earlier than the present cut-off of December 2024.
The old rules of the stability and growth pact – put into abeyance until next year on account of the Covid-19 pandemic – relied on estimated structural fiscal balances. These depended on computations of output gaps that often defied common sense. These output gaps often wrongly indicated that member countries’ gross domestic product was near potential, when – in truth – large output gaps existed. This set the stage for overly restrictive fiscal policy. The new framework rightly no longer uses this approach, ending output gaps as the key input.
But the new framework has its own pitfalls. The debt sustainability framework at its centre has as its single most important variable, the interest rate, that will prevail on future debt issuance over the medium term. Typically, this interest rate is derived from the current term structure of interest rates. If interest rates are distorted by PEPP reinvestments, as appears to be the case, how is a balanced debate on debt sustainability supposed to take place?
Figure 1. Foreign investors withdraw from Italy in late 2022 as Banca d’Italia purchases fall
Issuance of Italian government bonds vs demand by sector, in % of GDP, 4-quarter moving average
Figure 2. Foreign investors return to Spain, compensating for lower Banco de Espana purchases
Issuance of Spanish government bonds vs demand by sector, in % of GDP, 4-quarter moving average
The examples of Italy (Figure 1) and Spain (Figure 2) underline the influence of the ECB’s very large bond purchases. In the years since generalised quantitative easing started in 2015, the ECB and its owners, the national central banks, have displaced other financial actors – banks, households and foreigners – as the most active market participant. Net Eurosystem buying under PEPP ended in March this year, but PEPP reinvestments are continuing – and have been significantly skewed towards supporting the more indebted members of monetary union.
Figure 3. Strong correlation between Italian government issuance and ECB bond purchases since Jan 2022
Net issuance of BTPs by the central government versus ECB PEPP and PSPP net purchases, in €bn
Figure 4. Correlation between Spanish issuance and ECB purchases only half as high as for Italy
Net issuance of debt by the central government versus ECB PEPP and PSPP net purchases, in €bn
Monetary financing in the euro area is expressly forbidden by the European treaties. But ECB QE has been highly important in indirectly funding net new debt issuance on the euro periphery. Flow of funds data for Italy (Figure 3) and Spain (Figure 4) up to the fourth quarter of 2022 illustrate a revealing pattern. ECB purchases play a big role in both countries. Foreign investors, the most flexible and discerning investor class, are buying Spanish bonds, but have been exiting Italy, in the biggest wave of selling since the euro area debt crisis.
What needs to be done?
First, while PEPP reinvestments continue, transparency needs to improve. Data on PEPP reinvestments are highly obscure. The ECB publishes the figures only in two-month chunks of data, making it hard to discern just how purchases line up with issuance. Monthly – or weekly – data would help give a more accurate picture of what is going on.
Figure 5. Not just market forces – ECB buying plays a role in narrowing periphery spreads
Spread of 10-year sovereign bonds over Bunds, in basis points
Figure 6. Narrowing Italian yield spread opposite of normal behaviour when German and global yields rising
This matters because ECB buying makes it hard to discern ‘true’ market-based interest rates. This is akin to an exchange rate peg, where official intervention by the central bank makes it impossible to tell where the exchange rate would be without official intervention. As a result, it is possible that market forces drove the sharp decline in periphery yields since last summer (Figure 5), but it is also possible that the ECB has played a role. What is certain is that the fall in Italy’s spread is – by historical standards – highly unusual. Italy’s high debt-to-GDP means that the spread should rise when German and global yields rise. This has not happened recently (Figure 6).
Second, now that the pandemic is over, the ECB should bring forward the date for ending PEPP reinvestments, so that markets can find their own equilibrium for interest rates. In time for their next policy-making meeting on 27 July, ECB council members should think seriously about tabling a proposal to end PEPP reinvestments earlier.
The ECB’s role in periphery bond markets is multi-faceted. Steps such as last year’s announcement of the ‘transmission protection instrument’ are arguably verbal intervention.
The debate over Europe’s fiscal rules is now in high gear. By announcing an early end to PEPP reinvestments, the ECB would significantly contribute to increased interest rate transparency and buttress a welcome EU-wide effort on debt sustainability. This is an opportunity that Christine Lagarde, the ECB president, and her council colleagues should wholeheartedly embrace.
Robin Brooks is Chief Economist of the Institute of International Finance, Washington and David Marsh is Chairman of OMFIF.