Why Europe has a new weapon for bond ‘fragmentation’: QuickTake

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The European Central Bank is trying to head off a sovereign debt storm after raising interest rates for the first time since 2011. It worries about how markets could drive up borrowing costs for some of the most vulnerable countries that use the euro, such as Italy. . This type of potential explosion in government bond yields is known as “fragmentation”. The ECB has therefore devised a new weapon to curb tensions in the markets, a sign of its determination to combat the forces that almost destroyed the common currency a decade ago.

1. What is meant by “fragmentation”?

The term refers to an increase in borrowing costs for weaker countries in the eurozone relative to stronger countries. While the 19 economies in the currency bloc differ in metrics such as inflation, economic growth and debt, policymakers say some market moves don’t reflect those fundamentals and are too fast. States with the highest debt-to-gross domestic product ratios — notably Greece and Italy — saw some of the highest bond yields among major nations in June. The effort became urgent after Italy’s 10-year bond yield crossed the 4% mark, the highest since 2014. Moreover, the yield gap, or spread, above Germany , the benchmark for the continent, had widened. To make matters worse, a collapse of the Italian government could test the resolve of the ECB.

2. Why is this a recurring problem for the euro zone?

As euro members share a common currency, they implement their own fiscal and spending policies, leading to divergences that can swell over time, even with European Union limits on budget deficits . This is a unique challenge for the ECB, which has joined its peers around the world in buying government bonds to support a recovery from the 2008 global financial crisis. The EU’s founding treaties prohibit the ECB to finance member governments, and the massive purchase of bonds is testing this idea. The German Bundesbank, the central bank that provided the model for the ECB, has always denounced the dangers of such measures.

3. What does the new tool look like?

The backstop – dubbed the transmission protection instrument – ​​is a new bond-buying tool that is essentially open-ended in nature, with some aspects deliberately vague. It will be “activated to counter unwarranted and disorderly market dynamics,” the ECB said in a statement unveiling the TPI on July 21.

Read more: Here’s a look at the ECB’s new anti-fragmentation tool

4. What conditions are included?

All eurozone members are eligible provided they comply with EU fiscal rules and have a sustainable level of public debt. As the ECB raises rates, this borrowing becomes a bigger burden. The mechanism is designed not to interfere with other monetary policy measures, suggesting that bond purchases will be offset.

5. Is the new tool the only thing the ECB is doing?

No. The ECB has also reshaped its pandemic-era asset purchase program so that it can use reinvestments of maturing debt more flexibly. Officials chose not to impose strict threshold targets for such operations, people familiar with the matter said. Redirecting proceeds of expiring debt from core countries to troubled markets might be enough to keep speculators at bay for now.

6. What “crisis tools” have been deployed in the past?

The most famous is Mario Draghi’s Outright Monetary Transactions program, a bond-buying initiative that went unsolicited after markets took the former ECB president at his word when he pledged in 2012 to do “whatever it takes” to keep the euro intact. . His promise calmed a panic that started in 2009, after Greece unveiled its budget deficit and borrowing costs soared. This crisis led to bailouts for Greece, Ireland, Portugal and Cyprus as well as the rescue of banks in Spain. More recently came the ECB’s Pandemic Emergency Purchase Program, another bond-buying push that was crafted in days as Covid-19 swept across the continent in 2020. The PEPP, as we call it, ended up reaching around 1.7 trillion euros ($1.7). trillion) before the end of net purchases in March.

7. What are the challenges?

Politics and courts. At the ECB, not everyone has the same desire to throw a lifeline to countries they consider fiscally irresponsible. This could make it difficult to quickly agree on whether to activate the measure. The legality of the tool will also be in question – so far each of the ECB’s bond-buying programs has prompted legal action.

More stories like this are available at bloomberg.com

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