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ECB’s New Anti-Fragmentation Tool to Reduce Fiscal Risks as Rates Rise

The details released on the ECB’s new anti-fragmentation tool are consistent with the initial view that it could reduce debt sustainability risks while the ECB raises policy rates, Fitch Ratings says.

On 21 July the ECB raised interest rates for the first time since 2011, increasing three key rates by 50bp. It also introduced the “Transmission Protection Instrument” (TPI) under which it will be able to purchase eurozone countries’ bonds under certain conditions.

The TPI may ease concerns within the ECB Governing Council (GC) about tightening monetary policy. This is because it addresses the risk that higher rates could cause yields for some sovereigns to rise very sharply, and at different maturities, causing destabilising variance in monetary policy transmission, known as fragmentation, across the eurozone.

The TPI is not the ECB’s only tool with which to address fragmentation risks. The ECB’s first line of defence is the flexible reinvestment of Pandemic Emergency Purchase Programme (PEPP) redemptions. A third instrument is the Outright Monetary Transactions (OMT) programme. However, we believe eurozone countries have a strong incentive to avoid OMT activation as it is attached to a European Stability Mechanism (ESM) programme involving strict conditionality.

The TPI can be activated to counter what the ECB considers unwarranted, disorderly market dynamics that seriously threaten the transmission of monetary policy. The scale of purchases would depend on the severity of the risks to transmission and is not restricted ex ante. We believe this gives the ECB broad discretion over potential TPI interventions, but the TPI could still face legal challenges on the basis it violates ECB rules prohibiting the monetary financing of fiscal deficits. Christine Lagarde’s comment that purchases should be ‘proportionate to the achievement of the ECB’s primary objective’ seems to acknowledge this. The sterilisation of TPI purchases is a key feature distinguishing it from PEPP or the Asset Purchase Programme, although it is unclear exactly how it would operate.

To be eligible for the TPI, countries should be compliant with the EU fiscal framework, have a sustainable public debt trajectory, and sound and sustainable macroeconomic policies, with no severe macroeconomic imbalances. Eligibility will be decided by the ECB’s GC alone. The eligibility assessments should reduce the TPI’s erosion of market discipline effects on some highly indebted eurozone sovereigns, though there is uncertainty over how they will be implemented.

The EU fiscal framework is currently suspended, and it is unclear how this factor would be assessed until the suspension ends. The ECB will consider the views of the European Commission, ESM, IMF and other institutions to assess debt sustainability, as well as its own analysis. EU Countries will need to comply with the commitments in their recovery and resilience plans and with the Commission’s country-specific recommendations to implement sound and sustainable macroeconomic policies.

Fitch Ratings-London/Hong Kong-03 August 2022: The details released on the ECB’s new anti-fragmentation tool are consistent with the initial view that it could reduce debt sustainability risks while the ECB raises policy rates, Fitch Ratings says.

On 21 July the ECB raised interest rates for the first time since 2011, increasing three key rates by 50bp. It also introduced the “Transmission Protection Instrument” (TPI) under which it will be able to purchase eurozone countries’ bonds under certain conditions.

The TPI may ease concerns within the ECB Governing Council (GC) about tightening monetary policy. This is because it addresses the risk that higher rates could cause yields for some sovereigns to rise very sharply, and at different maturities, causing destabilising variance in monetary policy transmission, known as fragmentation, across the eurozone.

The TPI is not the ECB’s only tool with which to address fragmentation risks. The ECB’s first line of defence is the flexible reinvestment of Pandemic Emergency Purchase Programme (PEPP) redemptions. A third instrument is the Outright Monetary Transactions (OMT) programme. However, we believe eurozone countries have a strong incentive to avoid OMT activation as it is attached to a European Stability Mechanism (ESM) programme involving strict conditionality.

The TPI can be activated to counter what the ECB considers unwarranted, disorderly market dynamics that seriously threaten the transmission of monetary policy. The scale of purchases would depend on the severity of the risks to transmission and is not restricted ex ante. We believe this gives the ECB broad discretion over potential TPI interventions, but the TPI could still face legal challenges on the basis it violates ECB rules prohibiting the monetary financing of fiscal deficits. Christine Lagarde’s comment that purchases should be ‘proportionate to the achievement of the ECB’s primary objective’ seems to acknowledge this. The sterilisation of TPI purchases is a key feature distinguishing it from PEPP or the Asset Purchase Programme, although it is unclear exactly how it would operate.

To be eligible for the TPI, countries should be compliant with the EU fiscal framework, have a sustainable public debt trajectory, and sound and sustainable macroeconomic policies, with no severe macroeconomic imbalances. Eligibility will be decided by the ECB’s GC alone. The eligibility assessments should reduce the TPI’s erosion of market discipline effects on some highly indebted eurozone sovereigns, though there is uncertainty over how they will be implemented.
The EU fiscal framework is currently suspended, and it is unclear how this factor would be assessed until the suspension ends. The ECB will consider the views of the European Commission, ESM, IMF and other institutions to assess debt sustainability, as well as its own analysis. EU Countries will need to comply with the commitments in their recovery and resilience plans and with the Commission’s country-specific recommendations to implement sound and sustainable macroeconomic policies.

Despite some ambiguity over how it would work in practice, we expect the ECB to activate the TPI swiftly if fragmentation risks appear to be crystallising and a country is eligible. We believe it remains determined to avoid the level of fragmentation seen, for example, in 2011-2012 or in March 2020. As we stated in June, this should reduce the risk that sharp increases in interest costs negatively affect debt dynamics in highly-indebted eurozone sovereigns, such as Italy and Spain.

Nonetheless, it does not place a floor under sovereign ratings, since rating assessments would remain guided by broader credit fundamentals. We expect bond yields over 2022-24 will still be much higher than in the period since 2015. This will translate into higher interest payments over time, increasing fiscal strains in the eurozone’s high-debt sovereigns.
Source: Fitch Ratings

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