ECB action to save eurozone now only delays future dilemma

Frankfurt

THE European Central Bank's response to the coronavirus has calmed markets while setting it on a path that could test its commitment to the mission to keep prices stable.

With governments struggling to agree on joint fiscal action, president Christine Lagarde and her colleagues have ramped up bond-buying of vulnerable nations, soothing investor concerns over the cost of fighting the pandemic. Some economists predict the central bank will do more as soon as Thursday's virtual Governing Council meeting.

That strategy compensates for the eurozone's lack of a fiscal union or jointly issued bonds, by effectively mutualising debt via the central bank. It prevents borrowing costs in highly indebted nations such as Italy from spiralling out of control.

Yet it also assumes euro-area inflation doesn't accelerate. Few economists see that happening any time soon given the depth of the recession. But when it does, the ECB will have to consider withdrawing stimulus even if weaker economies can't afford higher debt repayments, potentially sparking another crisis.

"The ECB finds itself ever more politicised, as the asset purchases increasingly blur the lines between fiscal and monetary policy," said Anatoli Annenkov, an economist at Societe Generale in London. "As bond markets stretch their assessment of debt sustainability beyond this year, the risk is high that the ECB will have to continue to cover for wavering politicians."

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The central bank's crisis approach has so far been validated by financial markets, easing pressure on Italian bonds. Yet in a reminder of the uphill battle facing the ECB, Fitch Ratings downgraded Italy's creditworthiness to one level above junk, sending yields on 10-year Italian bonds up seven basis points to 1.80 per cent early on Wednesday.

While most economists expect the ECB to keep policy on hold on Thursday, they say its 750 billion-euro (S$1.15 trillion) pandemic bond-buying programme will need to be boosted by around 500 billion euros later this year.

Much depends on what governments agree when they speak on May 6. The signs are that nations such as Germany and the Netherlands will resist any grants to the worst-hit nations, instead insisting that relief is made up of loans that must be paid back.

Goldman Sachs has already raised questions about debt sustainability in southern Europe. Chief European economist Jari Stehn predicts Italy's debt load will climb above 160 per cent of GDP, with Spain and France also at risk if borrowing costs rise.

That seems a remote prospect with inflation, which was lower than the ECB's goal for years before the pandemic, now under further downward pressure. Former International Monetary Fund chief economist Olivier Blanchard argued last week that the probability of rapid price increases is extremely low, particularly in the euro area, "but it is not quite zero".

The experience of Japan - where government debt is more than twice GDP - shows that quantitative easing (QE) can keep interest rates low for years. The difficulty for the eurozone is that, unlike Japan, it has to balance the politics of 19 nations, some of whom are insistent that they don't become liable for others' debts.

It's an issue that has plagued the bloc since its birth two decades ago, and which has forced the ECB repeatedly to step in to resolve crises. By the end of 2020, its bond holdings will total close to 4 trillion euros, equivalent to about a third of GDP.

If inflation does pick up, the ECB still has options for averting a debt crisis.

Some economists, including Mr Blanchard, have suggested it consider raising the inflation goal from the current "below, but close to, 2 per cent". Multiple ECB officials have rejected that idea, but the target is due to be examined in Ms Lagarde's now-delayed strategic review.

In 2012 under then-president Mario Draghi, the ECB developed a tool to buy unlimited amounts of an individual country's bonds. It has never been used, largely because the government would have to accept economic conditions, but it's favoured by some politicians for Italy.

For its emergency purchase programme this year, the ECB scrapped a rule on how much of each nation's debt it can buy. Citigroup's Arnaud Mares, a former adviser to Mr Draghi, has suggested it should abandon broader guidelines that dictate how purchases are distributed across the bloc, making it easier to focus buying where most needed.

Such steps could open up the ECB to accusations that it's breaking the law by financing governments. It has already faced multiple legal challenges and a key one, a ruling by Germany's constitutional court on the QE programme that was launched in 2015, is due next week. BLOOMBERG