22 June 2022

Bruegel: A new European tool to deal with unjustified rising spreads

The European Central Bank announced on 9 June 2022 that it plans to increase interest rates in July and September to tame inflation. The expectation of rate increases has already resulted in a significant increase in spreads between euro-area countries. While some yield divergence is justified by fundamental economic differences (such as higher debt, weaker institutions or greater risk of political instability), the risk is that spreads increase beyond what is justified and spiral out of control. This is dangerous for the countries in question and ultimately for the euro itself.

Debt sustainability is unlikely to be jeopardised in the immediate future. The difference between interest paid on the stock of debt and nominal growth of output (r-g) is expected to remain favourable in the next few years. This means that debt-to-GDP ratios should fall. Servicing costs can be expected to increase only very gradually as policy rates increase, in part thanks to the generalised lengthening of the maturity of sovereign debts in the last decade. However, this still leaves a significant risk of self-fulfilling crises in euro-area sovereign debt markets.

It is thus the right time for a new ECB tool to prevent countries from experiencing such crises. ECB President Christine Lagarde mentioned in March and in subsequent press conferences the possible introduction of such an instrument. On 14 June, ECB Executive Board member Isabel Schnabel reiterated the idea. On 15 June, the ECB’s Governing Council finally announced that it will “mandate the relevant Eurosystem Committees together with the ECB services to accelerate the completion of the design of a new anti-fragmentation instrument for consideration by the Governing Council”.

However, the ECB has not yet indicated what the tool would look like in practice. We discuss how the tool could be designed and implemented, with the aim of neutralising the additional risk that monetary tightening could impose on some countries, while remaining within the bounds set by the EU Treaties.

First principles for a new anti-fragmentation instrument

A tool to deal with widening spreads at the current juncture should have three main features (as we discussed in more detail here): 1) it should be country-specific, 2) it needs to be applied only when the debt sustainability of the countries in question is validated by a process that ensures political legitimacy, and 3) it needs to be applied in conjunction with interest rate decisions in order for the whole framework to be consistent.

The tool would take the form of an asset purchase programme but should be applied only to those that face an excessive widening of their spreads. But what ‘excessive’ means is very difficult to determine in practice. ECB intervention in all cases in which yields increase significantly, without knowing whether these increases are justified by fundamentals, would put an end to market discipline. This would be difficult to reconcile with the EU Treaty and its interpretation by the EU Court of Justice. An ex-ante condition therefore, which would be both necessary and sufficient for the ECB to justify targeted asset purchases, would be for that country’s debt to be considered sustainable, and for that country to commit to maintaining sound policies so its debt continues to be sustainable. But should the ECB be able to decide this by itself without political approval? We would prefer the ECB to rely on an external risk assessment, to avoid the risk of the ECB looking politicised.

Bruegel

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