ECB tools effective, but Eurozone differences must be addressed

The ECB’s comprehensive and diversified response to the Covid-19 crisis has proven effective in providing relief in the sovereign, corporate and banking spheres, and the central bank appears ready to act further, says Crédit Agricole CIB Eurozone economist Louis Harreau. However, both the German constitutional court PSPP ruling and differing impact of the crisis across the EU pose challenges for the Eurozone.

What is your view on the latest ECB moves and what are the next steps you expect from it?

The ECB has gradually implemented a comprehensive and diversified response: (1) it significantly stepped up its purchase programmes, by adding €120bn to its QE programme and by creating the €750bn PEPP; (2) it dramatically entered the commercial paper market, hence avoiding a prolonged and destructive freeze of the short term funding market for corporates; and, more importantly, (3) it improved banks’ funding conditions by easing the TLTRO conditions in several significant ways.

In increasing its purchase programmes, the ECB is aiming first and foremost to ensure that sovereign spreads do not widen too much, which would trigger financial fragmentation and a tightening of monetary conditions. However, because of the programmes’ size and flexibility, the ECB can act discretionarily on any dysfunctional market segment — corporate bonds, commercial paper, covered bonds — and improve funding conditions for all big corporates.

Easing the TLTROs (rate as low as -1%, easing of collateral rules) will ensure that banks are able to grant credit to all economic actors, starting with SMEs and households.

These tools have proven to be effective so far: in spite of the economic developments, sovereign spreads have remained at manageable levels; banks have been able to face the astonishing increase in credit demand without tightening credit conditions; and, in spite of risk aversion, corporate spreads have come down from the peak of the crisis.

The ECB will continue to adapt to market and credit conditions. An extension of the PEPP seems to be a given: at the current pace, the ECB will have emptied the €750bn by the end of summer. On other aspects, the flexibility built into the purchase programmes should allow the ECB to adapt to most foreseeable market developments.

If the crisis were to be deeper and the recovery slower than expected, the ECB would reinforce its structural tools: increase monthly purchases in the QE programme and possibly ease TLTRO III conditions further, for example, extending the very favourable period with rates as low as -1% for the whole length of the operations.

What are the implications of the German constitutional court ruling?

The German constitutional court is more a threat to the EU’s architecture than to the ECB’s monetary policy. Of course, the court called into question the proportionality of the PSPP — a monetary policy tool — but the heart of its decision is rather that the European Court of Justice (ECJ) has not properly analysed the programme and that German institutions (government and parliament) have not exerted enough control over the ECB.

Following the ruling, several European institutions (the ECB, ECJ and European Commission) have rallied and the German government has adopted a constructive tone, which gives us hope that a solution will be found — before the end of the three month period — on the monetary policy side. The challenge, however, will be to make sure that, within this solution, the supremacy of EU law over national courts is guaranteed, which is the only way to ensure that European decisions (whether from the ECB or another body) apply uniformly to the EU as a whole.

On the operational side, however, there is a risk that the ruling — following the December 2018 ECJ ruling — could set limits for what the ECB can to: by highlighting the importance of the limits of QE in avoiding monetary financing, both courts imply that these limits (capital key repartition and 33% ISIN limit) cannot be removed, which could become a concern if the Eurozone needs a more proactive ECB.

Should we expect another Eurozone sovereign debt crisis?

The current crisis will significantly increase public debt in all Eurozone countries, and, worse, according to the latest economic data, the pandemic will increase divergence among countries: the strongest countries (Germany, Netherlands) will better withstand the pandemic and are likely to have a stronger recovery than the weakest countries.

Against this backdrop, the ECB has proven that it is ready to ensure favourable conditions for all Eurozone countries; the ECB is ready to compress spreads to ensure that there is no financial fragmentation in the Eurozone.

Nevertheless, the size of the shock, the dramatic deterioration of public finances and the economic divergences require more than monetary policy interventions. During the sovereign debt crisis, the Eurozone added several limited tools (ESFS, ESM, SSM, SRM) to the ECB’s support (OMT, VLTROs), which was enough to calm down the crisis, at a very elevated economic cost; this time, we think, the Eurozone cannot avoid providing a more comprehensive response — including a sort of debt mutualisation and fiscal transfers — or those responses will not be enough, no matter how the ECB is involved.