The ECB arms itself against bond market pessimism

Long before he was Italian prime minister, Mario Draghi pronounced the euro to be “like a bumblebee.” In 2012, the then-president of the European Central Bank called it “a mystery of nature . . . it shouldn’t fly but instead it does”. The economic union is still only half-complete, held together by political will and policy creativity. This week, his successors in Frankfurt unveiled their latest improvisation — one that will really matter for whoever takes over from Draghi as Italian prime minister.

One of the eurozone’s challenges is running monetary policy across a region where financial conditions vary dramatically. What happens when investors worry about one state’s debt sustainability? This concern can force up local interest rates, and can in effect mean that the central bank loses the ability to set monetary policy in that country. This is a bigger problem when rates are higher — and the ECB raised rates this week, by half a percentage point, for the first time in more than a decade.

That worry is why the ECB unveiled on Thursday the so-called “Transmission Protection Instrument”, which gives the central bank discretion to buy government debt from eurozone countries where “deterioration in financing conditions [are] not warranted by country-specific fundamentals”. In short, if the ECB thinks investors are panicking, it will step in to buy debt and so put a floor under bond prices.

Italy, where Draghi resigned this week as prime minister, is not the only problem, but it is the most pressing; its 10-year borrowing costs this week stood 2.3 percentage points above those in Germany, close to a recent three-year high. Italian debt stands at around 150 per cent of GDP.

It is worth being clear about what this all means. The shape of the market in eurozone debt is going to be constrained by the ECB, which will limit the difference in borrowing costs between nations. But for states that are likely to benefit, this process will also create new dynamics, in part because of the programme’s conditions.

States whose debt the ECB buys will need to comply with the EU’s fiscal rules, have a sustainable debt trajectory and make sure they follow any commitments they made in order to access post-pandemic EU funds.

This will be of particular importance for Italy. Draghi’s government had negotiated to receive around €200bn from the EU’s post-pandemic recovery fund — and, in return, to make Italy more competitive and business-friendlier. Rome, in short, was being incentivised by the rest of the bloc to push through painful reforms. Draghi said on Wednesday that, in order to receive the next tranche of cash — worth €19bn — Italy had 55 separate targets to hit by the end of the year. These reforms should be supported to avoid future crises by getting Italy growing.

It is unclear who will form the new government after the forthcoming election, which has been called for September. But the 17-month Draghi government may have laid down important guard rails for whatever comes next — since there is a steep price in EU funds for stepping away from his agenda. And by tying access to the TPI to continuing these reforms, the ECB has further sharpened incentives for the next government not to deviate from them — or risk a big sell-off of Italian debt.

But the instrument is not about Italian politics. It is, above all, about making sure that the eurozone’s bond markets are in line with ECB policy as it raises rates to navigate ongoing price shocks. Pressure will mount as European states shoulder the costs of this inflationary slowdown. Expect more improvisation to keep the bumblebee aloft.