The writer is chairman of Société Générale and a former member of the executive board of the European Central Bank.
The European Central Bank faces a dilemma. It must tighten its monetary policy in order to contain surprisingly high inflation and, at the same time, to prevent the fragmentation of financial markets in the euro zone.
History shows that fragmentation comes not only with a high economic cost for growth and jobs, but also potentially with a high political cost, with a loss of public confidence in European institutions. However, current instruments for combating fragmentation have significant limitations.
There is the Outright Monetary Transactions program to buy government bonds from crisis-hit countries in unlimited amounts. Created after former ECB President Mario Draghi’s “whatever it takes” speech in 2012, it comes with strict conditionality. To trigger the ECB’s power to buy sovereign debt under the OMT, a country must first have secured a rescue package from the eurozone financial assistance fund, known as the European Stability Mechanism. This is politically very difficult for the Member States to accept.
Additionally, under the treaty that established the ESM, bondholders could face debt restructuring if the public debt in question is deemed unsustainable. The other option is to reinvest funds from the ECB’s Pandemic Emergency Purchase Programme, which was set up to offset the damage of the Covid-19 pandemic. Its flexibility is welcome but the program is limited in size.
The ECB can solve the problem of fragmentation in two complementary ways. The first is to give ourselves the possibility of intervening to reverse any sovereign spread trend deemed unjustified. To convince the markets, such an instrument must have a potentially unlimited capacity. Also, it should avoid creating stigma and should therefore be light on conditionality. The challenge for the ECB is to draw the line between the powers of governments and those of the central bank.
A second way for the ECB to fight fragmentation is to avoid contributing to it in the first place. Indeed, the ECB is the only one of its main international peers to rely on the ratings of private agencies (all based in North America) to determine the eligibility and quality of guarantees that lenders can use to raise cheap funds from the central bank.
The eligibility conditions also apply to the ECB’s public sector purchase programme. The problem is that ratings tend to be pro-cyclical, underestimating risks when conditions are good and overestimating them in bad times. Moreover, once a Member State’s rating slips towards the threshold of losing investment grade status, the risk of losing eligibility can quickly generate destabilizing and self-fulfilling market dynamics.
The ECB partly acknowledged the shortcomings of the current situation by removing the eligibility conditions for Greek government bonds under the pandemic emergency purchase programme. In March, the ECB also announced that it “reserves the right to deviate also in the future from the ratings of credit rating agencies if justified, in accordance with its discretion in the context of monetary policy “.
The most obvious solution would be to eliminate any euro zone government ratings used as collateral, in line with the practice of all other major central banks. This would be a very strong signal that would help to reduce the fragmentation of financial markets in the euro zone.
Legal constraints notwithstanding, a first objection to such a measure could be the risks posed to the ECB’s balance sheet. However, such a risk would be minimal, as the government bonds purchased by the ECB are mainly held on the balance sheets of national central banks.
On its lending operations, the ECB is protected by what is effectively a double insurance system – for the central bank to suffer losses, the borrower from the commercial bank would have to go bankrupt and the collateral would then have to lose value. The assessment of banks’ soundness made by the Single Supervisory Mechanism, the system bringing together the ECB and the national central banks set up in 2013 as part of the eurozone banking union, is more reassuring.
By removing government bond ratings, the ECB would no longer be a source of potential liquidity risks for its domestic government bond markets. This would of course not remove the credit risk of government bonds, which would ultimately depend on the soundness of member states’ fiscal policies.
Michala Marcussen contributed to this article