Uncertainty over how flexibly the ECB can re-invest in euro area government bonds is exacerbating marketvolatility in highly indebted countries, especially Italy, as continued defi cits require higher private-sectorfunding as ECB net asset purchases end.
Given Italy’s (BBB+/Stable) public finance vulnerabilities – government debt-to-GDP of around 150%, annual gross financing needs close to 30% of GDP and a government deficit still above 5% of GDP – markets are rapidly repricing risks on Italian government bonds in the absence of full assurance around the ECB’s commitment to contain rates and/or spreads.
Italy’s reliance on the private sector is set to rise over the coming years as the government’s funding needs will remain elevated while the ECB winds down net asset purchases. This transition, which contrasts with the 2019-21 period, has important implications and needs to be managed carefully.
The ECB is committed to prevent fragmentation in the transmission of its monetary policy, hence the plan for a flexible reinvestment of principal repayments of securities under the pandemic-related programme (PEPP). However, many important details are not yet public.
The ECB’s self-imposed limit of not holding more than 33% of any outstanding bond issue (under the PSPP) could imply less capacity – or willingness – to reinvest maturing bonds of certain jurisdictions. In the case of Italy where the Eurosystem, via the Banca d’Italia, holds around 25-30% of outstanding debt, that additional flexibility could prove particularly valuable should the Italian Treasury face continued pressure on its financing costs given the country’s sizeable gross financing needs.
The ECB could use the reinvestments to purchase more securities of certain member states by shifting reinvestment across jurisdictions. It is unclear, however, whether the ECB could also accelerate reinvestment in securities of one member state prior to the maturing of debt securities of that specific jurisdiction.
From a policy perspective, such an adverse scenario could probably be mitigated if the ECB clarified its commitment to use reinvestments flexibly across jurisdictions and time. Under more stressed scenarios, the ECB could also announce a new programme to prevent further interest rate fragmentation as some market participants are already calling for, or alternatively, revive an old programme, specifically the ECB’s Outright Monetary Transactions (OMT) programme