On 21 July the European Central Bank (ECB) raised its key interest rate by 0.5% to 0%. It was the ECB’s first hike in over a decade and ended the era of negative interest rates. ECB president Christine Lagarde also introduced the bank’s new “transmission protection instrument” (TPI), a plan to prevent governments in the euro area’s periphery from being submerged by rising borrowing costs. The ECB says that it will buy the bonds of countries it believes are suffering “unwarranted, disorderly market dynamics”. As Marcus Ashworth on Bloomberg puts it, “TPI” might as well stand for “To Protect Italy”.
What’s the problem?
Italy’s borrowing costs are rising. This time last year Rome could borrow for ten years at 0.6% and for five years at a sub-zero rate, but the figures have leapt to 3.4% and 2.6% respectively. The collapse of Mario Draghi’s government and the prospect of a more spendthrift one coming to power has sparked the latest ructions. With a debt-to-GDP ratio of 150%, Italy can ill afford its borrowing costs to surge. What’s more, the spread between German and Italian ten-year government bond yields, a key gauge of stress in the eurozone, has risen from 1.4% in January to 2.4% this week – a sign that ECB interest-rate rises are hitting the bloc’s weakest states the hardest.
Did Lagarde’s intervention work?
Markets were underwhelmed. Ten years ago this week, Mario Draghi, Lagarde’s predecessor, famously vowed that “the ECB is ready to do whatever it takes to preserve the euro”. Those words made clear that the ECB would backstop eurozone sovereign debt and marked the end of the acute phase of the crisis. Lagarde hoped to emulate Draghi, but bond traders found the TPI plan vague. The message was “we do what we want, when we want”, Paul Donovan of UBS Global Wealth Management told Katie Martin in The Financial Times. And the scheme might well tempt traders to test the ECB’s intervention levels. While Lagarde lacks Draghi’s ability to charm bond traders, the real problem is that a decade ago inflation was barely above zero, says Martin. “Now it is 8.6%.” So there seems little scope for further potential monetary easing.
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What’s the worst-case scenario?
Soaring bond yields can become a self-fulfilling prophecy, bringing on the very insolvency that nervous traders have begun to fear. The backdrop for Italy’s public finances is not propitious: the country is almost as dependent on Russian gas as Germany. Even its world-class manufacturing and luxury goods will not be much help as the global trade cycle turns. Draghi’s successor is likely to be a less careful manager of the public purse. If that happens then the ECB may judge that a future rise in bond yields is “warranted” by reckless spending and decline to intervene.
So is this a new eurozone crisis?
Not yet. While Italian bond spreads have risen, they remain short of the 5% level they reached at the height of the sovereign debt crisis a decade ago. As John Authers notes on Bloomberg, while that crisis revolved around the solvency of a whole set of countries (Portugal, Italy, Ireland, Greece and Spain), this time it’s squarely about Italy. The others have got their public finances in order, for now at least. The Greek experience also suggests that when push comes to shove, politicians and populations are reticent about crashing out of the euro: it would turbocharge imported inflation and see the value of bank savings collapse (they would be re-denominated in a new, weaker currency). Still, high inflation is exposing the eurozone’s fault lines anew.
Would the ECB bail out Italy?
In practice, the ECB has often shown itself willing to fudge rules when eurozone survival is at stake. Lagarde has given herself plenty of wiggle room. As Willem Buiter notes on Project Syndicate, the flagship Draghi-era crisis tool – Outright Monetary Transactions (OMTs) – was never actually used because of its “robust eligibility requirements”. The new TPI framework loosens those conditions, with the ECB giving itself wide scope to determine if widening bond spreads are “warranted” (essentially, it will decide whether a country deserves to see its borrowing costs spike or not). The Commission will also help gauge if a state is running sound fiscal policy. That will raise the stakes in any budget battle between Brussels and Rome: “An assessment that a troubled country has breached the fiscal rules [could now make] it ineligible for monetary support,” says The Economist.
Will the new government cause trouble?
“Italy’s next government is unlikely to bring the country’s future in the eurozone into doubt,” says Jack Allen-Reynolds of Capital Economics. Euroscepticism has lost ground of late. A future government would also have a big incentive to stick with Draghi’s reform plans to keep receiving instalments of the €200bn Italy is due from the EU’s “Next Generation” Covid recovery fund.
So there’s nothing to worry about?
Talk of “Italeave” and eurozone break-up appears overdone for now, but markets are having to price in the risks of drama to come. Even if it doesn’t risk Italy’s euro membership, a new government in Rome won’t be happy with dutifully following the reform plans laid down by Draghi. “Looser fiscal policy” is likely, says Allen-Reynolds. “Parties’ demands for extra funds for their favoured policies was one of the reasons that the [Draghi] coalition fell apart”. The trouble is that could jeopardise the country’s access to the EU pandemic recovery funds.
The plan’s provision for jointly-issued EU bonds is a crucial first step towards the type of fiscal burden sharing that could ultimately fix the eurozone’s structural problems. Trouble in Rome could make it harder to persuade austere northern Europeans to agree to a repeat. As Luigi Scazzieri of the Centre for European Reform, a think-tank, told the Financial Times, “the whole idea of joint borrowing by the EU is at stake here”.
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