The ECB meets this Thursday 30 April. The Governing Council in our view will need to come up with “something” to show the Euro area can still count on a powerful policy backstop.
At least they need to be more generous and explicit on the treatment of fallen angels. Last week they went “half way”. At an unscheduled meeting last Wednesday, the ECB decided to “grand-father” investment grade assets which would be downgraded (down to a minimum of BB) as still eligible as collateral for bank refinancing.
This was a welcome move, but it was still less generous than what the Fed did the week before, since the ECB’s communiqué made no mention of applying the same clause to the corporate bonds the ECB buys outright through the Corporate Sector Purchase Programme and Pandemic Emergency Purchases Programme (unlike the Fed). In addition, the cut-off date for the grand-gathering clause is the rating status as of April 7, whereas it was March 22 for the Fed.
may decide if and when necessary to further mitigate the impact of rating downgrades…with a view to ensuring the smooth transmission of its monetary policy in all jurisdictions of the Euro areaECB Statement
True as well, the inclusion of Greek government bonds in the PEPP eligible universe implicitly signaled a readiness to support potential sovereign fallen angels, but in stressed situations, it is probably better to be explicit. We expect such an announcement by the ECB this Thursday that the same grand-fathering rules are applicable to outright purchases of both corporates and sovereign bonds, even if the decision by S&P to affirm Italy’s BBB rating on Friday could give them a bit more time.
But the market has increasingly shifted to considering not just the quality of the assets the ECB is purchasing but also the quantum.
Indeed, that the Italian sovereign spread could significantly widen at the beginning of last week although the ECB is buying securities via the PEPP at a rate of EUR 20bn per week is concerning. The figure of EUR750bn (on top of “traditional quantitative easing”) looked massive at first glance, but some quick calculations show that this might not be the case when it comes to Italy.
Indeed, between the likely borrowing requirement triggered by the soaring public deficit (EUR 180bn) and the need to roll-over roughly EUR 200bn in existing debt in 2020, if private investors choose not to support, roughly half the purchasing capacity of the ECB across all its existing instruments would have to be devoted to Italy alone (PSPP and PEPP, assuming 70% go to sovereigns). The wording of the PEPP legal document is ambiguous, but we fail to see how such a proportion could be acceptable. Article 5 offers lots of leeway in its second paragraph (“purchases under the PEPP shall be conducted in a flexible manner allowing for fluctuations in the distribution of purchase flows”) but the first paragraph still affirms the survival of the capital key as a benchmark on the stock of purchases (“The allocation of cumulative net purchases of marketable debt securities shall be guided, on a stock basis, by the respective NCBs’ subscription to the ECB’s capital”).
Our interpretation is that while the ECB is ready to diverge very significantly from the capital key for some time, there are limits to such a “skew”. This would call for a pre-emptive rise in the size of the PEPP. We do not expect such a “hard announcement” this week already, but we would expect Christine Lagarde in her Q&A to sound open to this. Some openness to a very long reinvestment strategy on PEPP would also help, but on this we think the ECB would probably want to remain evasive for now.
Note however that while we could easily see the PEPP exceeding EUR 1trn in the end, the possibility to raise the central bank’s fire power is not infinite.
Let’s start with Italy again. The current holdings of Italian public debt by the Eurosytem (via Banca d’Italia) stood at EUR 409bn before the pandemic started. We would expect Italian debt by end 2020 (excluding local government and short-term securities) to reach EUR 2270bn.
The ECB would rather avoid becoming the deciding force in a restructuring via the “Collective Action Clauses”, i.e. would rather keep its holdings of a single sovereign’s debt below 33%.
This would leave room for a maneuver of EUR 340bn across all forms of outright purchases. This could not cover the entirety of new 2020 borrowing requirement and refinancing needs if the other investors refuse to roll their exposure.
Assuming this first hurdle can be overcome, there would still be a snag.
The European Court of Justice endorsed OMT – and we think by extension all other forms of direct purchases of sovereign debt – partly because only a minority of one sovereign issuer’s debt would be held by the central bank. True, the PEPP legal document states that “the consolidation of holdings … shall not apply to PEPP holdings” but it far from obvious that the ECJ would accept this exception. This would create a hard stop to additional purchases of Italian sovereign debt beyond EUR 726bn. This is a lot of course, but this is still a limit.
Our point here is that we have the impression governments are dragging their feet on fiscal mutualization mechanisms to some extent because they know the ECB is providing massive support to the fragile states and can still up its game. Yet, the central bank could be nearing its own limits. As we have argued before, there is no free lunch for the “disciplinarian states”. If they reject fiscal mutualization, they will need to accept a comprehensive review of the central bank’s rules of engagement which would contradict their own monetary culture.