The political instability threatening to cut short Mario Draghi’s time as Italian prime minister has laid bare the challenges confronting his former colleagues at the European Central Bank as they prepare to unveil historic policy changes this week.
Christine Lagarde, who replaced Draghi at the helm of the ECB in 2019, is on Thursday expected to announce its first interest rate rise for over a decade while also outlining a new scheme it hopes will prevent higher borrowing costs from triggering another eurozone debt crisis. By the time it does the political situation in Rome could become even more volatile.
Italian bond yields rose sharply last week after the Five Star Movement, which forms part of Draghi’s national unity government refused to back him in a confidence vote, prompting the prime minister to offer his resignation. Though the president turned him down, Italians are now waiting to see whether Draghi is willing to remain in office, or whether the country will have snap elections. Any sign that the prime minister will step down is likely to trigger a rise in Rome’s borrowing costs.
The ECB’s scheme, dubbed the “transmission protection mechanism” by the central bank, is expected to be used to counter what it considers unjustified increases in a country’s financing costs — which it calls fragmentation — by buying its bonds. Lagarde told EU lawmakers last month that the ECB would not let this “fragmentation risk” happen and “hamper” the smooth transmission of its policy decisions. “You have to kill it in the bud,” she said.
But economists warn the upheaval in Italy highlights just how difficult it will prove for the ECB to disentangle the impact of unjustified speculation from more justified movements in yields based on a bleaker economic outlook.
“It makes the ECB’s life a lot more difficult,” said Spyros Andreopoulos, senior European economist at French bank BNP Paribas and a former ECB staffer. “In some countries, it could be perceived that the ECB is stepping in to pick up the pieces of the politicians’ failures.”
The ECB’s plan to tackle unwarranted fragmentation in eurozone bond markets has already met a frosty reception among officials of more frugal northern countries like Germany, Austria and the Netherlands.
They worry the ECB is overreacting as bond markets adjust to the prospect of rising interest rates. In trying to keep borrowing costs low for highly indebted countries, they fear the central bank will encourage fiscal lassitude and could stray into “monetary financing” of governments, which is against the EU treaty.
“If [the scheme] is going beyond the dividing line between monetary policy and fiscal policy it will be toxic politically in northern Europe,” warned Lars Feld, an economics professor at the Albert-Ludwigs-University of Freiburg who advises the German finance minister.
The spread between Italy’s 10-year bond yields and those of Germany rose last week to more than 2.22 percentage points, its highest for a month.
Investors are concerned early Italian elections could lead to a government led by Giorgia Meloni’s Brothers of Italy party, which is outside of Draghi’s coalition, has its roots in post-fascist politics and is leading opinion polls.
Erik Nielsen, chief economic adviser to Italian bank UniCredit, said: “What if rightwing candidates do well and the bond market sells off — should the ECB intervene then?”
Many economists believe this is the kind of fragmentation that the ECB should not try to fight against.
Francesco Papadia, a senior fellow at Brussels-based think-tank Bruegel and former head of market operations at the ECB, wrote on Twitter: “The ECB can’t do anything for countries that damage themselves.”
Silvia Ardagna, senior European economist at UK bank Barclays, agreed, saying: “Italy will not benefit from the activation of this tool if political uncertainty increases, Draghi resigns and early elections are held.”
But she added that the ECB’s new scheme “will be even more important to prevent contagion and spillovers from Italy to other sovereign markets while the ECB increases policy rates”.
Italy’s borrowing costs and the gap with Germany’s both remain far below the levels reached during the 2012 debt crisis, when Italian 10-year yields hit a record high of more than 7 per cent and the Italian-German spread peaked at 5 percentage points. On Friday, Italy’s 10-year yield was 3.26 per cent.
Jack-Allen Reynolds, senior Europe economist at research group Capital Economics, said the recent Italian political turmoil could intensify criticism of the ECB’s plan among its rate-setters, “as it is exactly the sort of situation that they don’t want to be dragged into”.
However, outright opposition to the new instrument is unlikely because even the most hawkish policymakers, who traditionally dislike buying bonds, know their hopes of raising rates well into positive territory could be frustrated if the eurozone is engulfed by a debt crisis.
Earlier this month, German central bank boss Joachim Nagel outlined several constraints he expected to be placed on the scheme, which he said “can be justified only in exceptional circumstances and under narrowly defined conditions”.
At an ECB governing council meeting earlier this month, Nagel joined with the heads of the Dutch and Austrian central banks to propose strengthening the scheme by giving the European Stability Mechanism bailout fund a role as an adviser on whether countries have sustainable fiscal plans.
This idea would be controversial in Italy and other southern European countries, where the ESM is viewed with suspicion because of the intrusive conditions and monitoring imposed on the countries it bailed out during the last debt crisis, including Greece, Spain and Portugal.
Source: Economy - ft.com
