The writer is chair of the Société Générale and a former member of the executive board of the European Central Bank.
The European Central Bank is faced with a dilemma. It needs to tighten monetary policy in order to rein in unexpectedly high inflation and at the same time prevent fragmentation of financial markets across the eurozone.
History shows that fragmentation comes not only with a high economic cost to growth and jobs, but also potentially a high political one, with a loss of public confidence in European institutions. However, the present instruments to address fragmentation have important limitations.
There is the Outright Monetary Transactions program to buy government bonds of crisis-hit countries in unlimited quantities. Created after former ECB president Mario Draghi’s “whatever it takes speech” in 2012, it comes with tough conditionality. To trigger the ECB’s power to buy sovereign debt under the OMT, a country must first have been granted a rescue program from the eurozone financial assistance fund, known as the European Stability Mechanism. This is politically very difficult for member states to accept.
Moreover, under the treaty that set up the ESM, bondholders could face debt restructuring if the government debt in question is deemed unsustainable. The other option is reinvesting funds from the ECB’s pandemic emergency purchase program, which was set up to offset the damage of the Covid-19 pandemic. Its flexibility is welcome but the program is limited in size.
The ECB can address the fragmentation issue in two complementary ways. The first is to equip itself with the possibility of intervening so as to reverse any sovereign spread trend considered unjustified. In order to convince markets, such an instrument must have potentially unlimited capacity. Furthermore, it has to avoid creating stigma, and thus needs to be light on conditionality. The challenge for the ECB is to tread the fine line between the remit of the governments and that of the central bank.
A second way the ECB can combat fragmentation is to avoid contributing to it in the first place. Indeed, the ECB is the only one of its major international peers to draw on the ratings of private agencies (all North America based) to determine the eligibility and quality of collateral that lenders can use to raise cheap funds from the central bank.
The eligibility requirements also apply to the ECB’s public sector purchase program. The trouble is that ratings tend to be procyclical, underestimating risks when conditions are good while overestimating them in difficult times. Moreover, once a member state’s rating slips towards the threshold for losing investment-grade status, the risk of losing eligibility can quickly generate destabilizing, self-fulfilling market dynamics.
The ECB has in part recognized the shortcomings of the current situation by waiving the eligibility requirements for Greek government bonds in the pandemic emergency purchase program. In March, the ECB also announced that it “reserves the right to deviate even in the future from credit rating agencies’ ratings if warranted, in line with its discretion under the monetary policy framework”.
The most obvious solution would be to eliminate any rating for euro area government used as collateral, aligning with the practice of all other major central banks. This would be a very strong signal that would help reduce fragmentation in the eurozone financial markets.
Notwithstanding legal constraints, a first objection to such a measure could be the risks posed to the ECB’s balance sheet. However, such a risk would be minimal as the government bonds bought by the ECB are primarily held on the balance sheets of national central banks.
On its lending operations, the ECB is protected by what is effectively a double insurance system – for the central bank to suffer losses, the commercial bank borrower would have to fail and then the collateral would have to lose in value. There is additional reassurance from the assessment of the soundness of banks made by the Single Supervisory Mechanism, the system comprising the ECB and the national central banks that was set up in 2013 as part of the eurozone’s banking union.
In removing ratings from government bonds, the ECB would no longer be a source of potential liquidity risks to its domestic government bond markets. This would, of course, not remove the credit risk from government bonds, which would ultimately depend on the soundness of the member states’ fiscal policies.
Michala Marcussen contributed to this article