The European Central Bank’s measures to counter eurozone fragmentation are gaining momentum amid growing concerns over Italian Prime Minister Mario Draghi’s clouded political future.
Technical action by the ECB to relieve upward pressure on Italian bond yields will be on the agenda at the Amsterdam meeting on June 8-9. Concerns over Italy’s political stability have resurfaced, although the latest figures from the Banca d’Italia show the country becoming a net creditor at the end of 2021. This change from its previous long-standing negative net international investment position has been largely ignored by financial markets.
The moves to narrow the widening spread between Italian and German bond yields — now the highest in more than two years — are part of a finely balanced deal on gradual monetary tightening. The central bank will announce on June 9 the end of its extensive quantitative easing through purchases of government bonds, which began in March 2015. From July, it is expected to raise interest rates, set at levels negative since 2014.
Christine Lagarde, President of the ECB, faces an acute political and financial dilemma, caused by a combination of the Russian-Ukrainian war, the aftermath of Covid-19, a decade of monetary accommodation and the latest rate hikes of American interest.
Europe is facing the highest inflation in 50 years, after 11 years in which the ECB did not raise interest rates. For Germany, this represents the longest period of monetary easing in peacetime since the founding in 1875 of the Reichsbank, the ancestor of the Bundesbank. The only comparable period was 1931-48, covering the global depression, the rise of Nazism, and monetary reform after World War II.
Anxious to safeguard her legacy, Lagarde does not want to go down in history as the ECB president responsible for permanent inflationary scars. The ECB’s board feared it was becoming “Europe’s Arthur Burns” – a reference to President Nixon’s ill-fated 1970s Federal Reserve Chairman who presided over the last pronounced bout of global inflation.
Likewise, she does not wish to provoke a repeat of the speculation about the break-up of the monetary union which prompted Draghi, like his predecessor, to launch “whatever it takes” measures in 2012 to maintain the cohesion of the eurozone.
Details of the expected decision to raise the ECB deposit rate from -0.5% to -0.25% or zero have yet to be set. Even the savviest members of the board are cautious about undermining Lagarde, who has declared his desire to raise rates in two 0.25 percentage point hikes in July and September.
The expected rise in key ECB rates in July will be the first hike since July 2011, four months before Draghi took over as president and quickly reversed earlier hikes. The rise in the euro’s annual inflation rate to 8.1% in May from 7.4% in April strengthens the position of board members in favor of a rise to zero before the summer break. A sharp rise in non-energy prices in May raised the possibility of a wage-price spiral, a prospect downplayed by ECB economists but underlined by Joachim Nagel, President of the Bundesbank.
Strained by nine months of underestimating inflationary pressures, Lagarde wants to display the unity of the ECB in Amsterdam. Part of the session – a post-Covid-19 revival of the ECB’s annual excursions to central banks in member countries – will feature social gatherings. This includes a dinner with board members and spouses and Dutch King Willem and Queen Maxima.
The meeting will be overshadowed by an increase in the spread between Italian and German government bonds to more than 2 percentage points, the highest since the Covid-19 outbreak in March 2020. This despite improving economic factors fundamentals in Italy, after a 6.6% growth in 2021, better than expected public finances and a historic change for Italy to become a net foreign creditor at the end of 2021. The country’s international investment position has changed to a product gross domestic positive of 7.4% after negative levels in previous years up to 20% of GDP.
The wide gap between nominal GDP growth and the average cost of debt has caused Italy’s debt-to-GDP ratio to fall to 150.8% in 2021, well below earlier estimates of an increase to 160%.
Despite the relatively good news, concerns about the widening Italian-German yield gap are being voiced at the highest levels in Rome, amid suggestions that the Draghi government should adjust its communications to address the issue. Rising borrowing costs will not quickly compromise debt sustainability, however, given the increase in average Italian public debt maturities to 7.6 years at the end of 2021 from 7.4 at the end of 2020.
Skepticism is growing over whether the Draghi government, in place since February 2021, has the power to stay in place to implement economic reforms, particularly on spending on EU’s next generation modernization projects before the next general elections scheduled for early 2023. After a meteoric career in high finance and public service, Draghi faces a period where the risk of failure is greater than the prospect of success. He was disappointed in February not to become Italian president. With another political stalemate expected, almost any eventual coalition government emerging next year is likely to weaken stability.
The strong minority on the ECB Council calling for a rapid end to monetary easing is aware of the need to counter fears of fragmentation in order to preserve the momentum of a gradual rise in interest rates to and from beyond zero.
However, no new facility from the ECB to reduce spreads is planned. Lagarde is expected to reiterate his previous insistence that the central bank can draw on instruments in its monetary arsenal, including flexibility in reinvesting maturing bonds in the portfolio of nearly 5 billion euros of government securities of the Eurosystem.
Nagel’s reference to “constructive ambiguity” in the ECB’s approach to controlling spreads could become a watchword. Significant help could come from the vastly different proportions and maturities of bonds from different countries maturing in the portfolios of national central banks in the coming years. Bonds held by the Bundesbank are geared towards shorter maturities than those in the Banca d’Italia portfolio.
Furthermore, the Bundesbank’s and ECB’s total holdings of German government bonds under all post-2015 QE are well above the 33% issuance share set as a limit in successive court rulings. Germans and Europeans. The same applies to the holdings of the Finnish, Dutch and Austrian central banks. Claiming the application of legal constraints, these four central banks could waive the reinvestment of bonds maturing for several months. The Banca d’Italia, whose holdings account for about 25% of Italy’s much larger overall public debt, below the 33% limit, could keep the reinvestment going. This would result in a relative acceleration of Italian bond redemptions – and a commensurate narrowing of spreads.
A move like this, which is expected to remain opaque under the ECB’s convoluted technical and legal rules, could buttress the technical position of the Italian bond market. However, if Italian uncertainty worsens, it is the politicians, not the ECB technocrats, who will have to find solutions.
David Marsh is President of the OMFIF.