As the Italian toll of the Covid-19 pandemic reached new heights last Sunday, Pope Francis broke the strict quarantine rules to visit the Church of San Marcello in central Rome. The pontiff went to pray for a miracle before a crucifix which, according to the pious, helped save the city from the plague in 1522.
Around him was a locked country and a continental economy in free fall, as the virus spread across Europe, freezing factories, rumbling borders, closing streets and confining hundreds of millions of citizens to their homes. Workers, business leaders and investors sought the deliverance not only of the almighty, but also of EU policy makers, whom they implored to prevent the crisis from turning into a lasting depression that could destroy the euro zone.
Last week it seemed that at least some of these prayers had been answered. On Wednesday evening, the European Central Bank stunned world markets with a bold plan to increase its asset purchases by 750 billion euros over the next nine months. European bond markets immediately recovered, with the scale of ECB intervention becoming evident, reducing the costs of financing the governments of Italy and Greece in Germany and France. “There are no limits to our commitment to the euro,” wrote Christine Lagarde, President of the ECB, on Twitter after the plan was unveiled.
But senior politicians have no illusions that the central bank’s decision alone can solve the region’s deep economic crisis. Lagarde will face skepticism in the ranks of her own institution and expand monetary interventions by the central bank as the downward economic spiral worsens. And eurozone leaders – deeply divided and focused on domestic policy responses to their own national crises – will need to join the single currency with coordinated policies if they are to rebuild a region that is entering deep economic contraction.
Europe is now facing its worst crisis since the war, said Paolo Gentiloni, EU Economic Commissioner. “The union project was born after a war. After a successful joint fight against this terrible pandemic, it could flourish or be considerably weakened. So for me, as an Italian, it is a wake-up call for all of us in the European institutions. “
So far the budget the response to the coronavirus has been stopping and largely national. The German, French, Spanish and Italian governments have defined major support plans, but, perhaps with the exception of Berlin, which will present an additional 150 billion euros in new loans on Monday, none yet scale needed to replace lost wages and canceled business.
Brussels has announced successive loosening of its fiscal rules, but for countries like Italy, there seemed to be little sign of solidarity from northern Europe – an impression worsened in Rome when Germany initially bans exports of medical masks to one of its EU partners.
Investor concern in recent weeks has been heightened by the ECB which, until Wednesday, was struggling to implement policies to meet the economic threat. It expanded its bond buying program and agreed to a vast new system to, in effect, pay the banks to lend to small businesses. But its initial reaction was unfavorable to the two emergency declines by the US Federal Reserve, massive asset purchases and repeated injections of cash into the banking system.
Ms. Lagarde further undermined market confidence with very damaging comments suggesting that she was not prepared to prevent the differences between Italian and German borrowing costs from exploding to dangerous levels.
In 2012, when a liquidation of the debt market tore apart the most vulnerable economies in the south of the euro zone, it took the promise of the ECB president, Mario Draghi, to do “all that was necessary” to prevent a self-fulfilling prophecy: that a country like Italy would be kicked out of the eurozone because its borrowing costs and debt were too high.
But Ms. Lagarde seems to back away from this commitment – a dangerous impression to give. Investors have started to refix the risk on sovereign bonds, sell Italian public debt and drive up yields. The spread, or interest rate differential, which widens sharply between the Italian and German public debt, suggests that the euro zone is heading for a crisis.
The absence of coordinated European action seemed all the more extraordinary given that the euro zone has important crisis-fighting tools created during its collapse with the breakup of 2012.
“In this pandemic, we face many difficult and complex problems. But this, preventing a new crisis in the euro area, is very obvious, “said Olivier Blanchard, former chief economist of the IMF. “When a doctor knows what to do but does not prescribe [the medicine], it is surely criminal. “
After an emergency meeting Wednesday evening, Ms. Lagarde made amends. The ECB’s € 750 billion emergency buy-in program was the type of intervention that the markets were demanding and that some governments – Italy, Spain, France – had demanded. The impact was immediate. Italian bond yields fell by around 80 basis points, or around a third, as did those of Spain, Portugal, France and Greece, all of which have high public debt.
The ECB also said it was ready to review the self-imposed limits on its bond purchases. These limits have been put in place – at the request of more hawkish members of the eurozone – to ensure that the central bank does not buy as many bonds as it is accused of directly funding national governments, which would violate EU law. But they have sown doubts in the minds of investors and some governments about the extent of the ECB’s commitment to intervene in bond markets to save the euro.
The ECB’s intervention brings immediate relief to the Italian banking sector, which continues to grapple with excessive levels of nonperforming and heavily indebted loans. Soaring yields – which goes hand in hand with falling prices – would have forced Italian lenders to reduce the value of their bond holdings and cut loans to cover losses, a nightmarish scenario for a struggling economy.
We are already worried about the impact of the crisis on the European banking sector. Stock prices have halved this year, reaching levels last seen in the 1980s. “It is inevitable that some borrowers will default,” said Clemens Fuest, president of the Ifo Economic Institute. Germany. “If banks lose capital as a result, capital regulation could force them to take out other loans, further exacerbating the crisis.”
The ECB has attempted to ease the pressure in two ways; first, by offering lenders some € 3 billion in liquidity at negative interest rates, which means they are paid to withdraw money from the central bank; and second, by allowing banks to absorb capital buffers to absorb any impact of defaults.
The question is whether it will be enough. Officials say the package will only help maintain bank lending and avoid a credit crunch if governments take their own concerted action.
“The ECB can provide liquidity to banks,” says Isabel Schnabel, member of the central bank’s executive board. “But that doesn’t necessarily mean that the banks are really lending to businesses in trouble because of the virus. This is where the state comes in. It can support the economy, for example by providing credit guarantees.”
Carlo Cottarelli, another former IMF official, believes the new ECB emergency program would be eligible to buy up to 68% of all new Italian government bonds issued this year – including maturing debt and new bond issues to finance stimulus measures. This gives Rome an important cushion.
“It’s a huge number,” he says. “It is not infinite. It’s not “all you need”, but it’s big enough. “
Mr. Cottarelli calculated on the basis of a government deficit of 5% of gross domestic product this year. The deficit can be much worse. Capital Economics estimates that the euro area budget balances will deteriorate between 10 and 15 percentage points of GDP this year. If that were the case, it could force the ECB to come back with an even bigger package and lift the limits on the bonds it can buy.
Germany’s 150 billion euro debt increase will give the ECB more room to maneuver, but ultimately Lagarde will have to challenge the Orthodox faction on the ECB council – led by the German Bundesbank – that ‘she has so far traveled on tiptoe.
When Ms. Lagarde took office last November, she promised a more consensual style of leadership. Instead, it is now showing that it is ready to overcome the reluctance of the monetary conservatives in its institution by considering an increase in the limits imposed by the ECB on its bond purchase program. But she faces intimidating battles as she seeks to manage a board deeply divided between doves and hawks.
“What I find most interesting is the political power game that takes place behind the scenes,” says Frederik Ducrozet, strategist at Pictet Wealth Management. “I underestimated his willingness to lead this battle.”
Just as when Draghi took office as President in 2011, the divisions within the ECB are reflected in a wider political battle in Europe between those who favor fiscal and political integration. narrower and those who distrust it.
This time, the divisions are rooted by the rise of Eurosceptic populism, which denounces in southern Europe a lack of solidarity in the euro zone and in the north is fed by fears that the rich countries will have to pay for the poorest. In a context of quarrels over the EU budget, followed by disputes between leaders over the closing of borders and the blocking of medical supplies, the first signs of this crisis are not reassuring.
“This is a global shock,” said Pablo Hernández de Cos, governor of the Bank of Spain. “Spain is already here, the virus is spreading quickly and so will the others. The budgetary response must not only be coordinated but common in the euro zone, which means debt pooled at least temporarily. This will prove to citizens the full power of European monetary union in their lives. “
France and Italy are among the most vocal advocates of radical budget action, as they urge eurozone leaders to support the ECB with their own tools. Critically, the European Regional Stability Mechanism rescue fund has € 410 billion in lending capacity which is currently unused. The authorities have considered the idea of offering precautionary ESM credit lines to several member states – a decision that could in turn unlock additional ECB firepower in the form of its monetary transactions, under which it can buy an unlimited number of short-term bonds.
Yet the idea of using the MES has become a political “nightmare” in Italy, says center-left MP and former Italian finance minister Pier Carlo Padoan, as Eurosceptic opponents of the government say it would lead to austerity and restructuring debt. “ESM is toxic. If you touch it, you will die. “
Another possible mechanism is a “corona bond”, which could be issued by the European institutions to help rebuild the economies of the member states. All of this is linked to long-standing pressure from capitals, including Paris, for the euro area countries to pool their budgetary resources more in order to strengthen the underlying structures of the single currency.
“The response to the pandemic must be energetic, coordinated, ambitious and urgent,” said Gabriel Makhlouf, governor of the Irish central bank. “Every government and every EU institution has to play its role.”
Officials were working this weekend on several joint tax proposals aimed at fighting the crisis. But aspirations for deeper tax integration have rekindled familiar divisions.
The opposition is led by Germany and the Netherlands, who have long been much more skeptical about risk sharing in the euro area. However, the ultimate position of Berlin has not yet been revealed. Angela Merkel, the German chancellor, has not publicly attacked other national leaders like Emmanuel Macron, the French president, who push these ideas. One of the side effects of the ECB’s bold move was to save time, thereby easing the pressure on the capitals of northern Europe to accept a more common burden-sharing in response to the crisis.
For many policymakers, time is exactly what the eurozone is missing, given the scale of the ongoing economic collapse. Bruno Le Maire, French Minister of Finance, launched a major challenge last week: “Either the euro zone reacts in a united way to the economic crisis and emerges stronger, or it is at six and seven and risks disappearing”.
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