Euro Macro and Rates: Rescue options are not straightforward – The aggressive sell-off in the Italian bond market today stirred up unpleasant memories of 2011-2012. Although Italian government bond spreads over Germany are still some way off the levels seen then, the pace at which spreads were heading higher earlier today was comparable. The risks to Italian bond yields remain skewed to the upside. New elections look very likely and recent opinion polls suggest that the two populist parties will once again be the only option to form a new government. This involves two clear risks. The first is a ballooning fiscal deficit that would lead to unsustainable debt dynamics. The second is Eurosceptic shift, which although is unlikely to manifest itself in early attempts to manoeuver a euro exit, could lead to major clashes between the Italian government and Europe.
Given the risks, it is worth considering what would happen in a scenario where Italy lost access to bond markets and needed external financial support. Below we set out the options that the European authorities have. These are via ESM programmes (see also here) or the ECB’s OMT programme (see here).
ESM loan – The ESM can provide loans to assist member states ‘in significant need of financing, and which have lost access to the markets, either because they cannot find lenders or because the financing costs would adversely impact the sustainability of public finances’. The loans are conditional on the implementation of macroeconomic reform programmes. The programmes are prepared and monitored by the EC in liaison with the ECB and possibly the IMF.
ESM Primary Market Purchases – The ESM can carry out primary market purchases of debt securities at market prices to lower the chances of a bond auction falling. There is a limit to the intervention of half of the final amount issued. As is the case with an ESM loan, the purchases are conditional on the implementation of macroeconomic reform programmes.
ESM Secondary Market Purchases – The ESM can carry out secondary market purchases of debt securities in the case that ‘lacking market liquidity threatens financial stability in the context of a loan either with a macroeconomic adjustment programme or without if the Member’s economic and financial situation is fundamentally sound’. The conditionality here is vague for countries with a programme, saying simply that ‘specific policy conditions will apply’.
ESM Precautionary Credit Line – The ESM can provide a credit line to help member states whose economic conditions are sound to maintain continuous access to market financing. If the member state does not comply fully with the criteria (such as public debt), it would be obliged to adopt corrective measures to address the areas of vulnerability.
ECB OMT programme – The ECB can carry out secondary market purchases (distinct from the APP that aims to ease monetary policy and expand the central bank’s balance sheet) aimed at ‘safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy’. A necessary condition is the ‘strict and effective conditionality attached’ to an ESM programme, including a macroeconomic adjustment programme or a precautionary credit line.
The shape of a rescue – As can be seen from the description of the programmes above, all the rescue tools would require some degree of conditionality. The ESM Secondary Market purchases or the ESM Precautionary credit line in combination with the ECB’s OMT programme are where the conditionality is somewhat more vague. This could provide more flexibility in negotiations with a member state that loses, or is in danger of losing, market access. Any future Italian government in that situation would probably resist the conditionality and would likely have considerable bargaining power given the likely contagion and adverse impact on the whole eurozone compared to smaller countries like Greece and Portugal. On the other hand, northern eurozone member states make stick to their guns. A dangerous game of chicken could arise. (Nick Kounis & Aline Schuiling)
Emerging markets: Investors singling out the weakest links – After a stellar 2017, non-resident portfolio flows to emerging markets (EMs) have fallen considerably this year, driven by rising US rates, USD strength and trade and geopolitical tensions. Still, the fall in total portfolio inflows is much more modest compared to previous episodes of EM turmoil (taper tantrum 2013, China/Fed concerns 2015). Partly reflecting a general improvement of (external) fundamentals in EMs, we are of the view that financial markets are so far more discriminative now and have ‘singled out the weakest links’ (in particular Argentina and Turkey). Looking at various financial market indicators, we conclude that contagion risks seem to be relatively contained, at least for now. That said, downside risks of a broader contagion to the EM asset class still remain. See for more background our note here published earlier today (Arjen van Dijkhuizen, Nora Neuteboom).