In 2012, Draghi eliminated the re-denomination risk by promising to protect the debt of Eurozone members. Lagarde risks letting it creep back
By Ferdinando Giugliano
Christine Lagarde has just blown a hole in Europe’s attempt to respond to the COVID-19 outbreak. The president of the European Central Bank was expected to show on Thursday that she would support lenders, businesses and governments as they deal with an unprecedented health crisis. This was her chance to mimic her predecessor, Mario Draghi, who helped ease the sovereign debt crisis in 2012 by saying he would do “whatever it takes” to save the euro.
Instead, in a dramatic press conference, she appeared to row back on the famous pledge. “We are not here to close spreads”, she said, responding to a journalist’s question—essentially saying that it wasn’t her job to keep a lid on the yields of sovereign bonds.
A later attempt at a clarification in an interview with CNBC didn’t calm investors. Italy’s and Greece’s 10-year bond yields rose by 50 basis points or more on the day to 1.82% and 1.99%. Even the interest rates on Spain’s, Portugal’s and France’s debt rose considerably. These are still manageable levels, but the sudden spike is worrying.
Lagarde’s statement is correct technically, but terrible in terms of messaging. She is right that the ECB’s mandate is to keep inflation at just below 2%. The spreads between government bond yields of different countries should reflect factors such as their fiscal credibility and growth prospects.
However, as the euro zone learnt all too well during the debt crisis at the start of the decade, there is a risk that investors may fear that a struggling country will leave the single currency (and hence, its bonds will be re-denominated in a devalued legacy currency). As a result, investors will demand higher bond yields, irrespective of a government’s credit-worthiness.
Draghi, in his famous 2012 speech, eliminated this so-called “re-denomination risk” by essentially promising to protect the debt of all euro-zone members. Lagarde’s statement risks letting it creep back—and at the worst possible moment.
There had been great hopes for Lagarde’s package of measures on Thursday. This week, Italy launched a sizeable fiscal boost of up to 25 billion euros ($28 billion) to support its health-care system and workers as demand collapses during a country-wide lockdown.
Other countries, including France and Spain, might follow. Lagarde should have made it clear that the ECB was there to defend these member states from market attack as they embark on these efforts. A chunky programme of new government bond purchases, accompanied by a clear verbal reassurance, would have gone a long way.
Instead, the ECB opted first for a targeted response. There are some impressive measures in the package, including a generous scheme of cheap loans for banks. In an unprecedented step, the ECB’s supervisory arm also lowered its prudential requirements for banks, to try to get more credit flowing to the economy. The central bank steered clear of cutting rates further, but launched an additional 120 billion euros in bond purchases, skewed heavily to the corporate sector.
This package was, in a sense, cleverly designed, but it lacked a crucial element: While Lagarde said the ECB would be flexible in choosing which government bonds to buy, there was no reference to getting rid of its self-imposed limits on how much debt it buys from each member state. These constraints are the main obstacle to a larger bond-purchase programme.
It is possible Lagarde is trying to maintain the pressure on the euro area’s political leaders to boost spending and devise a coordinated fiscal response to the virus. She said the current shock would need “first and foremost” a response from governments.
Euro-zone finance ministers meet on Monday. Germany has launched some targeted measures, but they don’t amount to much. Yet, if this is a game of fiscal brinkmanship, it would be a reckless gamble on Lagarde’s part. The eurozone is fighting a difficult battle, with enormous potential human and economic costs.
A central bank cannot solve this alone, but at the very least it should provide a calming presence so politicians and banks don’t have to deal with a market panic. On Thursday, Lagarde did exactly the opposite, raising fears that the ECB can no longer act as a stabilising force for the currency union. The ghosts of the sovereign debt crisis are haunting Europe again.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.