What Happened
The European Central Bank augmented its 30 billion euro (about $32 billion) a month program of quantitative easing with a Pandemic Emergency Purchase Program to buy an additional 750 billion euros (about $800 billion) in member country sovereign and corporate bonds until the COVID-19 crisis is over. The ECB also eased for the first time collateral standards and assets eligible for purchase, including Greek sovereign bonds, and included short-term corporate bonds in its buying.
Why It Matters
ECB President Christine Lagarde may finally have had her "whatever it takes" moment, equivalent to that of predecessor Mario Draghi's famous 2012 declaration that is widely credited with saving the euro, as she moves to save the European Union from crisis for the second time in a decade. It is no exaggeration to say the ECB may have precluded a potential sovereign default by Italy as it and other European governments are forced to ramp up borrowing to fight the economic effects of COVID-19 containment measures and a probable major economic downturn. Even Germany is considering the possibility of abandoning its constitutional "debt brake" and "black-zero" policy, which limits fiscal spending to fund new economic relief.
Statements Lagarde made after the Governing Council on March 12 were interpreted as indicating a willingness by the ECB to let yields on sovereign bonds increase according to the credit quality of the country issuing debt. Yields on 10-year debt issued by Italy and Greece, the euro area's two most indebted countries, subsequently rose to close to 3 percent and 3.75 percent, respectively. As recently as mid-February, both were yielding less than 1 percent, below comparable U.S. Treasurys.
Rising yields signal increased borrowing costs as deficit spending countries increase debt burdens. Yield curves for all euro sovereign bonds have shifted upward in the past week, including for German bunds, although those are still in negative territory. Sovereign bonds make up a critical part of bank assets in Europe, and rising yields could require recapitalization of banks at a time when public resources are needed to fight the pandemic. The "doom-loop" effect, in which the health of sovereign credit and bank solvency are related, was at the heart of the euro sovereign debt crisis that began in 2010 when Greece defaulted on its debt. The effect leads to a reinforcing spiral in which sovereign and bank insolvencies feed on each other and depress the real economy.
Sovereign bonds will still be purchased according to self-imposed limitations that require the ECB to buy bonds of all member countries, including those of Germany, in proportion to the ECB's capital key. The ECB has not lifted limits on buying more than one-third of individual issuers' outstanding stock of sovereign bonds. This limits the ECB's ability to buy boundless amounts of any individual country's bonds, something meant to counter ECB concerns of providing monetary financing for countries' budget deficits. Changing that would be controversial, and there are press reports that heads of central banks in Germany and the Netherlands only assented to augmented purchases after reassurances the prohibition on monetary financing would not be changed. To underline the idea of not monetizing deficits, the ECB statement did not address the liquidity issue directly, but included a jargon-laden rationale that said COVID-19 posed "serious risks to the monetary policy transmission mechanism" that "the ECB will not tolerate."
There is flexibility, however, which the ECB says "allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions." That effectively allows the ECB to perhaps bail out Italy in the current crisis. Adding purchases of short-term corporate bonds to the program is similar to what the Fed announced Feb. 17, and aligns policies of the two central banks.
Separately, Lagarde reportedly told EU leaders that a one-month lockdown of Europe for COVID-19 would reduce anticipated euro area growth by 2 percentage points from the ECB's forecast of 0.8 percent growth this year. A three-month lockdown would reduce growth by more than 5 percentage points.
The fiscal response needed to fight the pandemic will result in a huge surge in sovereign bond supplies as countries ramp up spending and increase budget deficits. In early March, the European Commission announced it would relax the enforcement of the bloc's limits on debt and deficits, which opened the door to governments across the European Union to announce significant increases in public spending. While these measures to some extent will mitigate the economic impact of the coronavirus crisis, they can create future problems for those governments that traditionally struggle to reduce their deficits (most of which are in Southern Europe). Governments including Europe globally have made pledges or are considering up to $2 trillion in additional spending, widening fiscal deficits in many countries.
There is even the possibility of joint euro-area bond issues, which is not as far-fetched as it sounded just a week or so ago. German Chancellor Angela Merkel has indicated a willingness to consider it rather than dismissing the prospect out of hand as she's done previously. Other Northern European governments like the Dutch government, however, reportedly oppose the idea. European officials are also looking at whether they can activate the $450 billion European Stability Mechanism set up during the last crisis, and are arguing over whether economic conditions should be applied to funds disbursed by it.
