February 7, 2023

The European Central Bank is using its pandemic-era bond-buying program to protect highly indebted eurozone countries from the effects of its decision to wind down stimulus programs in its bid to fight inflation.

The central bank closed net purchases in March as part of its pandemic emergency purchase program, but is concentrating reinvestments of maturing bonds on the more financially vulnerable members of the bloc.

According to Financial Times calculations based on central bank data, the ECB injected €17 billion into the Italian, Spanish and Greek markets between June and July, while its portfolio of German, Dutch and French debt fell by €18 billion .

“The deviation is now very large,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, about the ECB’s reinvestments. “It appears that the ECB has been very active in reinvesting almost all of the proceeds from core countries in peripheral countries.”

The reinvestments highlight the ECB’s eagerness to contain borrowing costs for countries like Italy and avoid a debt collapse in the eurozone as it pulls out of the accommodative monetary policy the bloc has pursued since the debt crisis a decade ago. has supported.

It comes after the ECB raised interest rates for the first time since 2011 following its decision last month to complete the PEPP program and a longer-term bond-buying program, the asset purchase programme.

Net PEPP purchases June-July 2022

Sven Jari Stehn, European chief economist at Goldman Sachs, said the “degree of flexibility that has been used” in reinvesting the proceeds of bonds that were part of the PEPP program was “slightly more than people expected”.

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ECB policymakers and investors are concerned that tighter monetary policy will widen the gap between the region’s strongest and weakest economies – the so-called fragmentation risk. These fears pushed the differential between the Italian and German benchmark 10-year bond yields to 2.4 percentage points in June, a level last seen amid the market turmoil in the early days of the pandemic in 2020.

The spread has since narrowed to around 2.1 percentage points after the ECB committed itself to tackling fragmentation. The ECB said last month that flexibility in deploying PEPP reinvestments would be the “first line of defense” in its effort to contain so-called spreads.

“I think it’s good that they are brave. . . it’s good for the markets to see that they’re putting their money where their mouth is,” said Ducrozet, adding that “the clear message is that they are using this flexibility almost to the maximum extent they could”.

The central bank also introduced a new transmission protection tool last month that can be used in the event that PEPP reinvestments fail to keep spreads in check. The tool allows the ECB to buy bonds on an unlimited scale from any country it believes is experiencing market pressures beyond the economic outlook. Investors have been watching Italian spreads cautiously to see when the ECB can step in, with many seeing 2.5 percentage points as a key figure.

While the ECB has yet to use the new tool, the use of PEPP reinvestments shows how eager policymakers are to keep spreads in check.

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Jari Stehn said this was “an activation of the first line of defense against fragmentation risk, but still means it’s an open question if and when the TPI will be activated”.