Growth uncertainty, European Central Bank intervention and the Italian debt

European Central Bank intervention provides a buffer against the uncertainty faced by European Union economies in the face of COVID-19. For the time being, this intervention has alleviated concern about Italy’s debt, but without it Italy is vulnerable to a debt crisis.

In the face of the challenges posed by the COVID-19 pandemic, the European Central Bank declared on 18 March 2020 that it “will not tolerate any risks to the smooth transmission of its monetary policy”. In this context, it launched a massive €750 billion Pandemic Emergency Purchasing Programme (PEPP) and announced a waiver of the minimum credit quality requirements for purchasing securities issued by the Greek government. On 7 April, the ECB extended the waiver to collateral in Eurosystem credit operations, and on 22 April it went further to ‘grandfather’ “marketable assets used as collateral in Eurosystem credit operations falling below current minimum credit quality requirements”. All euro-area sovereign debt is therefore acceptable for PEPP or as collateral. Haircuts may still apply, but the ECB also decided a 20% reduction in collateral valuation haircuts. The ECB’s intervention is a potent countervailing force to the heightened economic growth uncertainty brought about by the pandemic.

The waiver expires in September 2021, and this creates a potential cliff-edge effect. Past this deadline, commercial banks are not assured that they can use the bonds of low-rated countries as ECB collateral, and investors are not assured that countries can roll over their maturing debts through ECB purchases (see here for the significance of the debt collateral framework). Consequently, vulnerable countries could see their bond yields rise significantly because of the prospect of a downgrading below the ECB quality threshold. The cliff-edge effect is exacerbated by the reversal of the reduction in collateral haircuts. Restoring the haircuts to their higher values would further increase yields as a second-order effect. Vulnerable countries affected by these changes could be pushed into a bad equilibrium, with increasing debt dynamics and potential debt crises.

One country on the edge is Italy. The Italian debt-to-GDP ratio is expected to increase to 170% of GDP by the end of 2020, but with ECB intervention, its debt would revert gradually to pre-COVID-19 levels of about 140% within about a decade. However, if ECB abides by the September 2021 deadline, Italian spreads could shoot up, leading to an increasing debt trajectory and a potential debt crisis. Figure 1 makes the point clearly.

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