Fragmentation risk in the euro area: no easy way out for the European Central Bank

The European Central Bank (ECB) is about to enter the segment of the monetary policy cycle during which the objectives of price and financial stability might push it in opposite directions. For as long as monetary policy is eased, both objectives are generally fulfilled simultaneously. But as policy rates are increased and asset purchases end to tame inflation, the risk arises of market fragmentation among euro area countries.

The euro area faces this market fragmentation risk – i.e. some countries might experience a significant widening of their spreads disconnected from economic fundamentals – because of its peculiar and possibly incomplete institutional framework, with 19 sovereign governments that each have their own fiscal policy but share one currency and one monetary authority.

Given the favourable level of nominal growth compared to the interest paid on the debt (r-g), debt-to-GDP ratios are expected to fall, interest payments are expected to increase very gradually despite the ECB’s policy rate hikes, and thus solvency should not be a big issue for European governments in the next few years. However, there remains a risk of experiencing liquidity crises in euro area sovereign debt markets if the ECB does not do its part to rule out self-fulfilling bad equilibria.

Although still not considered a central scenario at this stage given that spreads are still well below previous peaks, the materialisation of this risk would be devastating for the euro area, because financial fragmentation could threaten financial stability and ultimately jeopardise price stability and the euro itself.

The ECB therefore needs to think of tools to complement its expected interest rate hikes by neutralising the effect on spreads of the most vulnerable countries.

We discuss the various policies that have been implemented in the past decade to deal with liquidity risks and explore which aspects could be used now that the tightening part of the monetary policy cycle is underway.

In the current circumstances, the important ingredients for such a tool are in our view that this tool needs to be country-specific, that it needs, given the difficulty of disentangling solvency and liquidity situations, to be applied only when debt sustainability of the countries in question is validated by a political process, and that it needs to be applied in conjunction with interest rate decisions so the whole framework is consistent.

The existing tool that comes closest to having such a set of characteristics remains outright monetary transactions (OMT). Its country-specific nature serves the purpose of being targeted, and the European Stability Mechanism (ESM) programme that is required to accompany it provides political legitimacy. But the OMT/ESM framework is designed as a measure for when there is a high probability of a solvency crisis while now, a tool is needed for non-debt-crisis times. Moreover, ESM involvement slows down the decision-making process, and the political compromises that ensue do not necessarily constitute first-best policy.

None of the options in the current ECB toolbox is fully satisfactory from an economic and democratic perspective in the current situation. Therefore, we propose a new option with the right economic ingredients and a process ensuring that it is politically legitimate and within the bounds set by the European Union Treaties, but that, contrarily to OMT, could be applied in real time to neutralise the additional risk that monetary tightening could pose for some countries.

Whatever tool the ECB decides to use, old or new, in the current situation, we also argue that it needs to rethink its collateral framework in order to abandon its counterproductive reliance on private ratings, which creates some unnecessary uncertainty over the safe-asset status of European sovereign bonds.