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New ECB Tool May Reduce Fiscal Risks; Policy Choices Still Key

The ECB’s planned ‘anti-fragmentation’ programme could reduce the risk that sharp swings in sovereign borrowing costs negatively affect debt dynamics in high-debt eurozone sovereigns, Fitch Ratings says. This would support the creditworthiness of these sovereigns, but progress on debt stabilisation and reduction will remain key to our sovereign credit assessment.

The ECB governing council’s (GC) unscheduled meeting on 15 June discussed widening spreads on some so-called “peripheral” government bonds. The GC confirmed the ECB will reinvest maturing bonds purchased under the pandemic emergency purchase programme flexibly across jurisdictions, and mandated the relevant Eurosystem committees to design “a new anti-fragmentation instrument.”

Some divergence in bond yields is unsurprising in a currency union of sovereign states with independent fiscal policies, and can translate into different financing conditions to the real economy that do not hinder the ECB’s ability to achieve its mandates. However, if yields increase very sharply and at different maturities, this can cause excessive differences (fragmentation). Such market moves can become self-fulfilling, as in 2011-2012, when the eurozone experienced a level of fragmentation that the ECB will be keen to avoid.

Spreads on peripheral bonds remain far from their 2011-2012 levels and the increase in short-end yields has been relatively contained. However, yesterday ECB president Christine Lagarde said the bank wanted to nip the “possibility of financial fragmentation” in the bud.

Reaching agreement within the GC and designing an effective anti-fragmentation tool will be challenging. Above-target inflation raises the bar for ECB sovereign bond purchases. Actively seeking to compress yields across the eurozone could imply leaning against overall monetary policy direction. This raises the prospect of country-specific interventions with some conditionality to address the prohibition of monetary financing of fiscal deficits and to avoid legal challenges. But GC members’ views will differ on the extent of conditions and how they would be monitored.

We think the new facility will probably involve the ECB purchasing bonds of specific countries to contain spreads. In theory, the outright Monetary Transactions Programme (created in 2012 but never used) could do this but it is subject to European Stability Mechanism conditionality, which countries may be unwilling to subject themselves to.

Press reports suggest the new tool may have lighter conditionality. This could be through compliance with the regular European Commission recommendations on eurozone economies or that the ECB would sterilise purchases to prevent exacerbating upward price pressures.

Nevertheless, we expect the GC to reach a compromise by the 21 July monetary policy meeting as failure to announce the new facility could trigger a negative market reaction. An effective instrument to limit fragmentation and excessive market volatility would reduce the risk that sharp interest cost rises negatively affect debt dynamics in high-debt sovereigns. But it would not place a floor under sovereign ratings since support could be withdrawn if a sovereign no longer fulfilled conditionality, and the interest service burden is only one of a number of considerations in determining the overall fiscal position (see previous Fitch research).

The new facility will aim to avoid adverse self-fulfilling market dynamics as the ECB tightens policy, but bond yields will still be much higher than in the period since 2015. This will translate into higher interest payments over time and reducing fiscal space for eurozone sovereigns.

An important factor in our sovereign assessment will be how domestic fiscal policy settings adjust to this new environment. Countries that target and achieve fiscal primary surpluses will be most likely to place debt/GDP on a downward path, which would typically be a positive factor in our rating assessment.

Economic growth remains key to underpinning positive debt dynamics. Against the backdrop of the Ukraine war and the energy crisis, effective use of Next Generation EU funds and implementation of recovery and resilience plans will become increasingly important, particularly in the peripheral high debt countries which are NGEU’s largest beneficiaries.
Source: Fitch Ratings

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