Much may depend on whether Germany is willing to bail out Italy
As the Italian death toll from the Covid-19 pandemic reached grim new heights last Sunday, Pope Francis broke 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 the pious believe helped save the city from plague in 1522.
Around him was a country in lockdown and a continental economy in freefall, as the virus spread across Europe, freezing factories, snarling borders, shuttering high streets and confining hundreds of millions of citizens to their homes. Workers, business leaders and investors were seeking deliverance not only from the almighty, but from EU policymakers, who they implored to stop the slump from turning into a lasting depression that could destroy the eurozone.
For a moment last week, it looked like at least some of those prayers had been answered. The European Central Bank stunned global markets on Wednesday night with an audacious plan to expand its asset purchases by a vast €750bn over the next nine months. European bond markets immediately rallied as the scale of the ECB’s intervention became plain, reducing the financing costs of governments from Italy and Greece to Germany and France. “There are no limits to our commitment to the euro,” Christine Lagarde, the ECB president, wrote on Twitter after the plan was unveiled.
But senior policymakers are under no illusion that the central bank’s move can alone cure the region’s profound economic crisis. Ms Lagarde will need to confront scepticism within the ranks of her own institution and expand the central bank’s monetary interventions as the downward economic spiral worsens. And the euro area’s leaders — deeply divided and focused on domestic policy responses to their own national crises — will need to rally behind the single currency with co-ordinated policies if they are to rebuild a region entering a profound economic contraction.
Europe now faces its worst crisis since the war, says Paolo Gentiloni, the EU’s economics commissioner. “The union project was born after a war. After a successful common fight against this terrible pandemic it could flourish, or it could be dramatically weakened. So this for me as an Italian is a wake-up call for all of us in the European institutions.”
So far the fiscal response to the coronavirus has been halting and overwhelmingly national. The German, French, Spanish and Italian governments have outlined large support packages, but, perhaps apart from Berlin, which on Monday will present a supplementary budget with €150bn in new borrowing, none yet on the scale needed to replace lost wages and cancelled business.
Brussels has announced successive relaxations of its fiscal rules, but for countries such as Italy there appeared to be little sign of solidarity from northern Europe — an impression compounded in Rome when Germany initially banned exports of medical masks to any of its EU partners.
Investor alarm in recent weeks was amplified by the ECB, which until Wednesday struggled to deliver policies to match the scale of the economic threat. It expanded its bond-buying programme and agreed a vast new scheme to, in effect, pay banks to lend to smaller companies. But its initial reaction compared unfavourably with the US Federal Reserve’s two emergency rate cuts, massive asset purchases and repeated injections of liquidity into the banking system.
Ms Lagarde further undermined market confidence with highly damaging comments suggesting she was unwilling to stop differences between Italian and German borrowing costs from blowing out to dangerous levels.
In 2012, when a debt market sell-off ripped through the eurozone’s more vulnerable southern economies, it took then ECB president Mario Draghi’s promise to do “whatever it takes” to prevent a self-fulfilling prophecy: that a country like Italy would be ejected from the eurozone because its borrowing costs, and its debt burden, were too high.
But Ms Lagarde appeared to be walking back from that commitment — a dangerous impression to give. Investors began to reprice the risk of sovereign bonds, selling off Italian government debt and sending yields soaring. The sharply widening spread, or interest rate differential, between Italian and German government debt, suggested the eurozone was heading for a crisis.
The lack of co-ordinated European action seemed all the more extraordinary because the eurozone has considerable crisis-fighting tools created during its brush with a break-up in 2012.
“In this pandemic we are dealing with many difficult and complex issues. But this one, preventing another eurozone crisis, is very obvious,” says Olivier Blanchard, a former chief economist of the IMF. “When a doctor knows what to do but doesn’t prescribe [the medicine], it surely is criminal.”
Following an emergency meeting on Wednesday evening, Ms Lagarde made amends. The ECB’s €750bn Pandemic Emergency Purchase Programme was the kind of intervention that the markets had been calling for and which certain governments — Italy, Spain, France — had been demanding. The impact was immediate. The yield on Italian bonds fell by some 80 basis points, or about a third, as did those on Spain, Portugal, France and Greece which all have high public debt.
The ECB also said it was prepared to review the self-imposed limits on its bond-buying. These limits were put in place — at the behest of more hawkish eurozone members — to ensure that the central bank does not buy so many bonds that it is accused of directly funding national governments, which would break EU law. But they have sowed doubts in the minds of investors and some governments about the extent of the ECB’s commitment to intervene on bond markets to save the euro.
The ECB’s intervention provides immediate relief for Italy’s banking sector, which is still saddled with excessive levels of non-performing loans and heavily loaded with government debt. Soaring yields — which go hand in hand with falling prices — would have forced Italian lenders to mark down the value of their bond holdings and trim back on lending to cover losses, a nightmare scenario for an economy deep in trouble.
There are already worries about the impact of the crisis on the European banking sector. Share prices have halved this year to levels last seen in the 1980s. “It is inevitable that some borrowers will default,” says Clemens Fuest, president of the Ifo economics institute in Germany. “If banks lose equity as a result, capital regulations could force them to call in other loans as well, exacerbating the crisis.”
The ECB has attempted to ease the strain in two ways; first by offering lenders some €3tn of cash at negative interest rates that mean they get paid to take money from the central bank; and second by allowing banks to eat into capital buffers to absorb any hit from loan defaults.
The question is whether it will be enough. Officials say the package will only help to keep banks lending and avoid a credit crunch if governments take concerted action of their own.
“The ECB can provide the banks with liquidity,” says Isabel Schnabel, executive board member at the central bank. “But that doesn’t necessarily mean that banks really lend to companies in trouble because of the virus. That’s where the state comes in. It can support the economy, for example by giving credit guarantees.”
Carlo Cottarelli, another former IMF official, believes the ECB’s new emergency programme would be eligible to buy up to 68 per cent of all new Italian government bonds issued this year — including maturing debt and new bond issues to fund stimulus measures. It gives Rome a significant cushion.
“This is quite a number,” he says. “It is not infinite. It is not ‘whatever it takes’ but it is pretty large.”
Mr Cottarelli made his calculations on the basis of a public deficit of 5 per cent of gross domestic product this year. The shortfall may be much worse. Capital Economics estimates that eurozone budget balances will deteriorate by 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 whose bonds it can buy.
Germany’s €150bn debt increase will give the ECB more headroom, but eventually Ms Lagarde will have to challenge the orthodox faction within the ECB council — led by Germany’s Bundesbank — which she has so far been tiptoeing around.
When Ms Lagarde took on the role last November, she promised a more consensual leadership style. Instead, she is now showing she is prepared to override the reluctance of monetary conservatives in her institution by considering an increase to the ECB’s self-imposed limits on its bond-buying programme. But she faces daunting battles as she seeks to manage a board deeply divided between doves and hawks.
“What I find most interesting is the political power play that is going on behind the scenes,” says Frederik Ducrozet, strategist at Pictet Wealth Management. “I underestimated her willingness to fight this battle.”
Just as when Mr Draghi took over as president in 2011 the divisions within the ECB are mirrored by a broader battle being played out at political level in Europe between those in favour of closer fiscal and political integration and those suspicious of it.
This time the divisions are entrenched by the rise of Eurosceptic populism, which in Europe’s south decries a lack of eurozone solidarity and in the north feeds on fears richer countries will have to pay for poorer ones. Against a backdrop of bickering over the EU’s budget, followed by spats between leaders over border closures and medical supplies being blocked, the early signs in this crisis are not reassuring.
“This is a global shock,” says Pablo Hernández de Cos, governor of the Bank of Spain. “Spain is already there, with the virus spreading fast, and it will be the same for the rest. The fiscal response should not only be co-ordinated but common in the eurozone, meaning mutualised debt at least temporarily. This will prove to citizens the complete power of European monetary union in their lives.”
France and Italy are among the most vocal advocates of radical fiscal action, as they urge eurozone leaders to back the ECB with tools of their own. Critically, the region’s European Stability Mechanism bailout fund has €410bn of lending capacity which is currently unused. Officials have been examining the idea of offering precautionary ESM credit lines to multiple member states — a move that could in turn unlock further ECB firepower in the form of its Outright Monetary Transactions, under which it can buy unlimited amounts of shorter term bonds.
Yet the idea of using the ESM has become a political “nightmare” in Italy says Pier Carlo Padoan, a centre-left MP and former Italian finance minister, because the government’s Eurosceptic opponents say it would bring austerity and debt restructuring. “The ESM is poisonous. If you touch it you die.”
Another possible mechanism is a so-called “corona bond”, which could be issued by European institutions to help rebuild member states’ economies. All this is linked with a longstanding push by capitals including Paris for euro area countries to pool more of their fiscal resources to strengthen the single currency’s underlying structures.
“The response to the pandemic needs to be forceful, co-ordinated, ambitious and urgent,” says Gabriel Makhlouf, governor of the Irish central bank. “It needs every EU government and institution to play its part.”
Officials were working at the weekend on several joint fiscal proposals aimed at tackling the crisis. But aspirations for deeper fiscal integration have reawakened familiar divisions.
Opposition is led by Germany and the Netherlands, which have long been far more sceptical about eurozone risk-sharing. Yet Berlin’s ultimate position has yet to be revealed. Angela Merkel, the German chancellor, has not publicly attacked other national leaders such as Emmanuel Macron, the French president, who are pushing these ideas. One of the side-effects of the ECB’s bold move was to buy time, alleviating pressure on northern European capitals to agree to more joint fiscal burden sharing in response to the crisis.
For many policymakers, time is just what the euro area lacks, given the scale of the economic collapse under way. Bruno Le Maire, France’s finance minister, put the challenge starkly last week: “Either the eurozone responds in a united manner to the economic crisis and emerges stronger, or it is at sixes and sevens and is in danger of disappearing.”