11 augustus 2011
Author: Andrew Balls

No Turning Back: The ECB Brings Its Balance Sheet to Bear on Italy and Spain

​Clearly the European Central Bank cannot solve all of the eurozone’s problems. But by preventing a downward spiral of contagion it can hope to restore stability.

The engagement of the ECB’s balance sheet is a significant positive development. But there remains huge uncertainty, together with large technical and political execution risk.

Given the extent of the challenges, it makes sense for investors to remain cautious on the threats facing the eurozone and the global systemic implications.

The European Central Bank has crossed the Rubicon. By buying Italian and Spanish government bonds, it has brought a much-needed and credible external balance sheet to bear. There is thus the potential for an end to damaging games of chicken between the eurozone’s monetary and fiscal authorities and, therefore, stabilizing the eurozone’s systemically important government bond markets. But there remains huge uncertainty, together with large technical and political execution risk.

Since the onset of Europe’s debt crisis, national governments and the ECB have struggled to come up with a coherent and timely policy framework. The “too little, too late” approach and the open conflicts and disagreements, including between the German government and the ECB, meant that the crisis could not be contained. Today, it is not just Italy and Spain that are challenged by contagion but also France, at the core of the eurozone, risks being contaminated.

European leaders at their July 21 summit signaled a more decisive approach, including a clear signal that they would separate efforts to deal with the solvency problems facing Greece and quite likely Ireland and Portugal with the bigger and frankly more important effort to build a firebreak between those small countries and Italy, Spain and the European banking system. However, while the political leaders were perhaps hoping that this would be enough to restore stability and encourage private investors to re-enter eurozone markets, there was the clear problem of the time it will take for the governments to expand the role of the European Financial Stability Facility (EFSF) and the significant execution risk. There are also clear issues in terms of the design of the EFSF, a fund that is not a joint and several liability of the eurozone members.

The engagement of the ECB’s balance sheet is therefore a significant positive development. Using its balance sheet, the ECB has the ability to stabilize the Italian and Spanish bond markets. It does not face the operational challenges of the EFSF. The big questions pertain to its willingness to play this role and, in turn, the willingness of governments to deliver their side of the bargain: fiscal adjustment, in a controlled manner, and the move to greater fiscal integration.

There are reasons for ongoing skepticism. Thus far in the crisis there has been little to promote great confidence in the overall policy response. Moreover, rather than a clear and transparent plan, the ECB has adopted a “wait and watch what we do” plan. Market participants need to assess what the ECB does on a daily and weekly basis in order to assess their seriousness of purpose. Moreover, the ECB’s earlier foray into purchasing government bonds in the case of Greece, Ireland and Portugal does nothing to instill confidence.

That said, there is a huge difference between buying Greece, Ireland and Portugal government bonds, given the real solvency challenges those countries face, and buying the government bonds of Italy and Spain. In the case of these two large and systemically important countries, recent spread widening is largely the result of technical contagion rather than a fundamental reassessment of their prospects. There is a legitimate case for ECB intervention to promote more orderly markets. This is more akin to the large-scale purchase of government bonds by the Federal Reserve and the Bank of England than the ECB’s prior interventions in the three small countries.

Jean-Claude Trichet, ECB president, has stated that he intends to keep on the ECB’s balance sheet the Italian and Spanish government bonds that the central bank buys. He has also made clear that he hopes that the period during which the ECB will be buying government bonds will be limited and that the expansion of the EFSF in the autumn will obviate the need for ongoing purchases by the ECB.

But clearly the ECB can choose how aggressively to act in the meantime and thereafter. It has the ability, the question is on the willingness. There are no similar constraints as those that currently apply to the EFSF. Over time, the EFSF is likely to be better used as a vehicle for recapitalizing banking systems, as needed, and for removing Greek, Irish and Portuguese assets from the ECB balance sheet than for large-scale secondary market intervention.

It is clearly unfortunate that the ECB could not communicate a unanimous vote by its Board members in favor of its recent markets intervention. Yet the ECB is not the only central bank with internal divisions. There were three dissenting votes at the Federal Reserve as the U.S. central bank gave the conditional commitment to keep its policy rate on hold until mid 2013 at this week’s meetings. The Bank of England has had three-way splits on its votes. Meanwhile, it is a positive that the leaders of Germany and France provided their implicit backing for the ECB’s expanded role in their Sunday night statement on the eve of the launch of the ECB’s new program. The Group of Seven countries also provided backing, for what that is worth.

Clearly the ECB cannot solve all of the eurozone’s problems. But by preventing a downward spiral of contagion it can hope to restore stability and provide the environment for an orderly handover to eurozone governments that must ultimately do their part to promote ongoing eurozone stability. This is likely to take the form of controlled fiscal adjustment, common eurozone bond issuance or cross-border guarantees – via the EFSF or a successor to the EFSF – deeper fiscal integration, and structural reforms to promote growth. Again, the question is of the willingness of eurozone governments to take this approach to build greater stability. The ECB can be a bridge, but a fiscal solution is required for stability. In aggregate, the eurozone’s public and private debt burdens are no worse and in some respects more manageable than those of the U.S. There are significant political and coordination challenges to be overcome, however, for the comparison to be truly relevant. 

It is hard to see how Greece, for the foreseeable future, would be able to become a member of a deeper fiscal union and there are very significant question marks over Ireland and Portugal. Yet, these uncertainties and even the tail risk of a country leaving the eurozone do not need to prompt systemic collapse for the rest of the eurozone. What is needed, however, is a truly credible firebreak. The fiscal authorities have signaled a different approach. The ECB is buying Italian and Spanish government debt. It is hard to see how the ECB can step back from its role other than if stability has been restored without prompting to crisis to morph to an even larger and less manageable phase.

We are not at the beginning of the end of the eurozone crisis. We may, however, be at the end of the beginning. Given the extent of the challenges, it makes sense for investors to remain cautious on the threats facing the eurozone and the global systemic implications. We now need to see the ECB demonstrate its seriousness of purpose and for eurozone governments to respond in kind.