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ECB's Whatever-It-Takes Toolbox Means Italy Must Blink First


By Paul Gordon


  • The ECB of 2018 is far more powerful than in the 2012 crisis

  • Central bank’s biggest backstop tool comes with conditions

The European Central Bank has a decade of crisis-fighting experience to draw on to confront market turmoil in Italy, the euro zone’s third-biggest economy.

The institution that once failed to stem a blowout of bond yields with tentative purchases of sovereign debt from affected countries has morphed into a more self-confident actor with a toolbox that includes a meaningful, if untested, backstop to defend the single currency.

The downside is that Italy might have to make unwelcome concessions to access that assistance. The surge in the nation’s bond yields appeared to stop, at least for now, in early Wednesday trading. Here’s a look at what could be on offer should the situation deteriorate.

Verbal Intervention

Mario Draghi’s defining moment as ECB president came in July 2012 when he unexpectedly pledged to do “whatever it takes” to preserve the euro. That reined in spiraling bond yields in stressed southern economies, though it was subsequently backed by an actual tool: Outright Monetary Transactions.

More recent verbal intervention was the ECB’s statement in 2016 after the U.K.’s vote to leave the European Union. It reminded everyone that it can provide as much liquidity as banks need.

Outright Monetary Transactions

Under OMT, the ECB would make large-scale purchases of Italian debt, bringing yields down and ensuring the government can fund itself. It’s a powerful tool -- and one never used. Its mere creation ended the 2012 crisis.

There is a catch: The country must apply for it, and must also go to the European Stability Mechanism, the euro area’s bailout fund. And an ESM rescue comes with conditions requiring economic reforms, something unlikely to appeal to Italian populists who won elections by railing against austerity and pledging higher spending.

“OMT is only available for countries that have an ESM program. If Italy goes to the ESM, asks for help and meets the conditions to pursue sound policies, then there would be no need for help to begin with.”
-- Holger Schmieding, Berenberg chief economist

One advantage for Italy, ironically, is that it has so much debt -- 130 percent of gross domestic product -- that the ECB is unlikely to run immediately into self-imposed constraints. To avoid accusations of monetary financing it sets a cap of 33 percent on the share of any country’s debt it can buy.

“The ECB still has ample room to buy Italian bonds -- they own under 25 percent of Italian debt, which puts them comfortably below the issuer limit so they have room to buy another 150 billion euros in debt.”
-- Frederik Ducrozet, Banque Pictet senior economist

Securities Markets Program

The SMP was an earlier ECB bond-purchase program started in 2010 to address “severe tensions” hampering transmission of monetary policy. Crucially, the ECB absorbed that extra liquidity elsewhere to keep its policy stance unaffected. The program was terminated when OMT was announced, but it shows how the ECB can invent tools tailored to individual crises.

QE Tweaks

Italy’s bond yields have soared but might be even higher if the ECB weren’t buying its debt as part of quantitative easing. QE was created to revive inflation in the whole euro area though, and the ECB has signaled it will end this year. Officials can’t justify extending or increasing it just for one country, which would be considered monetary financing of the government. More QE could be a tool only if Italy’s problems hurt the inflation outlook for the rest of the bloc.

“This is only likely in case of a protracted crisis, so it is possible but unlikely to materialize in the near term, especially as the ECB would want to avoid being seen as political.”
-- Antoine Bouvet, Mizuho International strategist

The ECB could have operational flexibility to temporarily increase some purchases either while buying continues or as it reinvests maturing debt when it’s over. Of the 30 billion euros ($35 billion) a month of QE acquisitions, an average of about 3.6 billion euros are Italian government bonds. Such tweaks would jar with the spirit of its monetary policy and in any case, the ECB is committed to stick to the so-called capital key over the program’s duration, which links the size of holdings to the relative size of each euro-area economy.

Free Cash

The ECB could reinstate its crisis-era innovation of free loans to banks. The last program of targeted longer-term refinancing operations offered cash for four years at an interest rate of zero that could drop even lower if the bank lent the money on.

That liquidity tool could be useful if Italian banks struggle to raise funding, but might not assuage investors concerned that the real problem is government overspending or a potential euro exit.

Similarly, the Bank of Italy can fund solvent lenders directly through Emergency Liquidity Assistance, at a penalty interest rate. That lifeline kept Greek banks afloat in 2015 as the government haggled over its bailout.

It’s double-edged. ELA is temporary and requires regular approval by ECB policy makers. When they capped the amount Greek banks could access, the government was forced to impose capital controls.

Cyprus also found itself unable to avoid that outcome, though both countries are still in the currency bloc. But those are minnows in comparison with Italy.

— With assistance by Jana Randow, John Ainger, Piotr Skolimowski, and Alessandro Speciale

(Updates with Italian bond yields in third paragarph.)


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