MNI SOURCES: Divisions Remain Over ECB's New Crisis Tool

Large remaining differences over the design of a new mechanism to contain any blow-out in peripheral bond spreads will be difficult to resolve by next week’s European Central Bank meeting, but officials will aim to convince markets that the tool has major firepower even if some of its details are never made public, Eurosystem sources told MNI.

ECB staff are evaluating five proposals which they expect to whittle down for the Governing Council as they seek to incorporate binding conditions but avoid the stigma of the existing Outright Monetary Transaction programme, a senior central bank source said. Discussions have taken place between the ECB and national central banks, with Austria and Germany making the most demands on conditionality, though sources said there proposals to tie these to the EU’s excessive deficit procedure have been dropped and there should be agreement by September or October.

Some aspects of the anti-fragmentation tool may be kept in reserve even once finalised, sources said, noting that it will be a backstop and that reinvesting maturing bonds acquired under the ECB’s Pandemic Emergency Purchase Programme will remain the first line of defence against volatility.

“Details of the plan will not be disclosed – so size, scope, what size of spreads constitute – these will not be spelled out,” said one source. “A key strength of the AFT will rest on its mystique.”

ITALIAN BONDS

A key argument for the tool is that it is necessary to support peripheral bond markets as rates rise, and the crisis now engulfing the government in Italy, where Prime Minister Mario Draghi offered his resignation on Thursday, highlights both the need to get it into place and the importance that it comes with clear conditionality. (See MNI SOURCES2:ECB Mulls Crisis Tool As Officials Debate Spreads)

“Events in Italy in recent days have underlined our dilemma,” one source said. “We must not have a tool that offers governments a free hand over fiscal policy in these very difficult times, but we must be able to stave off unjustified speculative moves by the bond markets.”

Conditionality will be central to the tool, which is likely to face scrutiny by Germany’s Constitutional Court, though it must also avoid the stigma attached to the OMT facility, whose use is contingent on agreeing programmes with the European Stability Mechanism.

Early proposals to tie the programme to the EU’s excessive deficit procedure have been dropped, with an EU official telling MNI this would have put finance ministers in a difficult position and perhaps made them reluctant to enact the procedure.

“It would also have meant too much meddling by the ECB in fiscal policy,” the EU source said.

The new tool’s fiscal conditions are likely to look beyond headline metrics such as those specified in European Union debt rules, one of the eurosystem sources said.

“Rather than being dependent on Brussels, I would put it the other way around: we are actually setting conditions for countries in order to drive others toward what already should be in place. There's no free lunch, and we've always said that.”

The ECB will make allowances for spending in support of structural reform, the source said, adding that it could also consider use of funds provided by the NextGenerationEU financial aid programme. “When the country is at least showing, or trying to, put in their share of work to tackle fragmentation, then the ECB is giving the other 50% share of the work, and then jointly, we will have a good outcome.”

CALIBRATION

The tool could also be calibrated at short intervals, perhaps on a weekly basis.

“It will be a very sensitive tool that will be prone to very sensitive calibration, from meeting to meeting or week to week, especially in the beginning,” the source said. “We also want to find the actual root cause of fragmentation, otherwise the tool was not effective, or we wouldn't need a tool.”

Sources acknowledged the danger that markets might react with initial disappointment to a lack of detail, though they added that the ECB would convince investors of its firepower.

“On Thursday, whether we learn something or not, it will be a volatile couple of days. And the true reactions will only be visible the week after, when markets open again on Monday,” one source said.

Another source agreed that Thursday’s announcements were likely to include “constructive ambiguity -- in part because that is what is wanted, and part because the details may need still to be ironed out.” But, the source added, the Governing Council is united in its aim of preventing fragmentation and accepts that any plan should convey the impression that it is unlimited in size.

“It will be difficult to agree on all the technicalities by next week as there are still some very large differences on the plan itself. However, there will be an embryonic outline with more than enough firepower already available if needed,” the official said.

An ECB spokesperson declined to comment to MNI.