Dispatch€s from Frankfurt: ECB: French Connection
Staying on the sidelines
The ECB is likely to stay on the sidelines until further notice in all but the most adverse market scenarios following the French parliamentary elections. Conditions for activation of OMT and TPI are not likely to be fulfilled, and the bar for the ECB’s other tools is mostly very high. Investors are likely to stay cautious on European assets in what could be a game of many innings.
As the French parliamentary election has drawn nearer, France’s bond spreads – and Italy’s – have widened, and crisis talk in financial markets has intensified. (Readers will forgive me for being unable to resist posting the cliché chart with spreads!)
Source: Macrobond
The case for caution
First off, my view remains that while a full-blown crisis is unlikely, investors are likely to stay cautious on European assets until further notice. While the most likely scenarios for the endgame are benign, in my view, there is plenty of scope for interim political frictions to worry markets.
In contrast to the eurozone crisis a decade ago, any concerns from France would be far from existential for the EU and the euro due to an improved policy framework. However, (i) immediate acceptance of the policy framework cannot be taken for granted in all political scenarios (ii) activation of existing backstops relies on acceptance of the framework, and in any case conditions for activation are unlikely to be fulfilled currently (more on this below); and (iii) a prolonged period of uncertainty could ensue, possibly extending until the 2027 presidential election.
This could be a game of many innings.
Whither the ECB?
Against this backdrop, investors are asking one question above all others: what will the ECB do?
So this post is about the ECB’s toolbox. I will not attempt to prognosticate the election, or the politics – but instead look at the implications across various scenarios.
But before getting into the particulars, I want to gain some altitude and look at the situation from a bird’s eye view.
As ever, understanding the peculiarities of the European framework is important context – readers who want to go straight to the detail can skip to the toolbox sections. (And in case you missed it, you may also want to read European Crisis Redux?)
What’s different about the euro
Europe’s monetary union features one monetary policy and twenty separate fiscal policies – as many as there are countries.
Furthermore, euro area sovereigns borrow in a currency they do not themselves issue: it’s the ECB that issues the currency (by providing liquidity to banks). The ECB is independent and does not have a role as lender of last resort for sovereigns (as is implicitly the case for other advanced economies’ central banks).
This left euro area sovereigns vulnerable to self-fulfilling liquidity concerns in markets. Turbulence from Greece’s restructuring in 2009-10 engulfed other countries, sparking a sovereign debt and banking crisis.
Because they can
Over time, the ECB has developed tools to address markets’ sovereign liquidity fears through bond market interventions.1
This has cemented the fact that in a crisis case, the buck stops with the ECB: the Frankfurt institution is the only player that has both unlimited firepower and the ability to deploy it immediately in financial markets.
Having tools that can flexibly intervene in government bond markets is powerful, and may be important for euro area (financial) stability, but is not without challenges for the ECB itself.
The bank needs to make sure that any “crisis fighting” does not interfere with its mission of delivering 2% inflation.
While the ECB can and should help with unfounded sovereign liquidity concerns, it cannot and should not help in the case of sovereign insolvency.
It needs to be mindful of moral hazard: having the ECB as a backstop in the bond market may increase the risk that governments run unsustainable fiscal policies.
Which gets us to toolbox design.
Inspecting the toolbox (1): bond market intervention
The ECB’s bond market intervention tools - namely, the OMT and the TPI - are intended to kill all these birds with a single stone.
Creating separate tools to address markets’ sovereign liquidity concerns is meant to insulate the “monetary policy stance” – what the ECB needs to do to achieve 2% inflation – from crisis fighting (this is sometimes called the “separation principle”: one problem, one tool).
Solvency and moral hazard are addressed in the conditionality for the activation of the ECB’s sovereign bond market tools. And here we get into the specifics.
Activation of the OMT requires conditionality in the form of an outright fiscal bailout program or a – softer – precautionary program.
The ECB’s TPI press release is quite explicit that the ECB can buy if a country experiences a worsening of financing conditions that are “not warranted by country-specific fundamentals” [my italics]. Its criteria for purchases of a country’s bonds include
compliance with the EU fiscal framework, including a country not being in an Excessive Deficit Procedure (EDP)
fiscal sustainability, ascertained on the basis of debt sustainability analysis.
Certainly the first criterion is not currently fulfilled: the EU Commission has very recently opened an EDP against France. More broadly, the ECB cannot (be seen to) be riding to the rescue in scenarios where political decisions trigger bond market reactions.
Conclusion 1: activation even of the tailor-made bond market intervention programs cannot be taken for granted.
Inspecting the toolbox (2): interest rates, asset purchases, and bank funding
What about the other tools?
Policy interest rates and (regular, large scale) asset purchases are there for the ECB to do its day job – achieving its inflation target. The implication is that for the ECB to change course on such tools would require scenarios in which the inflation outlook is affected.
Policy rates: fiscal scenario in the driving seat. The answer here depends substantially on the post-election fiscal policy scenario.
The programs of both RN and NFP in principle contain sufficient fiscal boost for France for it to be meaningful on a euro area level if either win the election and fulfil their fiscal pledges. All else equal, that should induce tighter ECB rates policy than in the absence of such a boost.
That said, fulfilling these fiscal pledges would challenge the EU framework, which in turn could precipitate market concerns. In the most severe scenarios of this kind where confidence and the economy are affected materially, the ECB could even end up cutting rates.
June business surveys indicate an uncertainty shock for the French economy. How important this proves to be for the euro area will depend on election results and post-election scenarios. For now, recent developments probably increase the likelihood of a September rate cut – unless there are signs by then that the fiscal boost scenario becomes more likely.
PEPP: not as flexible. The ECB has already decided that reinvestments on the PEPP are being reduced in 2H and are scheduled to end in December. In principle, PEPP reinvestments flexibility would have been the first line of defense, as the buying could be tilted towards French bonds. However, the wording in the relevant ECB statement explicitly relates this flexibility to the pandemic, making it difficult to use in case of dislocations in French bond markets.
APP: a pure inflation instrument. While the PEPP has had a dual mission (policy stance for inflation and financial stability) from its inception, this is not really the case for the APP, the ECB’s “regular” QE program. The APP is an instrument for the monetary policy stance and as such highly unlikely to be activated outside of very severe scenarios in which there is a risk that inflation may end up running persistently below target.
LTROs: comfort zone, but requires banking contagion. Given its official role as lender of last resort for banks, providing liquidity to the French or euro area banking system through longer term bank funding (“Long Term Refunding Operations”) is in principle much more comfortable terrain for the ECB. However, dislocations in bank funding would likely be required for this kind of intervention, which again seem very unlikely except in the most severe of scenarios.
If needed, I would expect these to be “plain vanilla” long term liquidity operations – not TLTROs. That is, liquidity would not be provided at a subsidized rate to banks as the aim would not be to induce lending to the real economy.
Conclusion 2: the bar for the activation of the ECB’s other tools is very high.
Photo credit: Alexis Minchella on Unsplash
An early prototype was the – now defunct – Securities Markets Programme (SMP).