ECB faces challenges over Italy, Brexit — and its own strategy
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The European Central Bank is facing serious challenges: rising tensions between Brussels and Rome, doubts about monetary policy and worries about Britain crashing out of the EU without a deal.
A closely watched poll of purchasing managers published on Wednesday also showed that the region’s businesses are struggling to come to terms with increased global trade tensions — and that the export-led slowdown is beginning to affect the much larger services sector.
Such problems have not changed the ECB’s mind since its last big meeting six weeks ago. The ECB still insists it will halt its €2.5tn quantitative easing programme — which played a vital role in fuelling the eurozone recovery — by the end of the year. It argues that growth is still sufficiently strong and broad-based to forge ahead with its plans to phase out QE — the product of arduous negotiations within the ECB itself.
The ECB’s governing council is meeting on Thursday and its statement, to be released at 13:45 CET, will almost certainly confirm those plans. Policymakers are also expected to reiterate that they expect to keep interest rates at record lows “through the summer” of next year.
But when ECB president Mario Draghi speaks to the press at 14:30, he is all but certain to face questions about Italy, the ECB’s own strategy and Brexit-related risks.
Rome vs Brussels
In an unprecedented move, the European Commission has rejected the draft budget proposed by the populist government in Italy, one of the region’s biggest economies.
The tensions over the populist government’s plans to run a substantial budget deficit have pushed up Rome’s borrowing costs. The yield on Italy’s ten-year government bond is now 3.59 per cent, compared with 2.95 per cent when the ECB governing council last met in September.
Rome is angered at the ECB’s refusal to extend QE. But the central bank has observed little sign that Italy’s travails have affected other parts of the single currency area. Bond prices and borrowing costs for Spain and Portugal, two other parts of the eurozone’s so-called periphery, have not moved much.
And while Moody’s downgraded Italy’s debt on Friday, the rating agency’s verdict on Rome was better than feared. That has kept Italian borrowing costs manageable — at least for now for now at least.
Strategy for 2019
Even after the ECB winds down QE purchases, it will confront big questions about its future strategy.
One issue is what to do with its hugely expanded balance sheet; another is how to prepare markets for higher interest rates in the future.
These matters will be affected by the choice of Mr Draghi’s successor, who will take office in November next year. But the outgoing ECB chief will play a crucial role in coming months.
One big topic is how the bank will reinvest the proceeds of bonds that were bought under QE and have now matured. According to the ECB’s own calculations, such reinvestments will amount to almost €200bn over the first nine months of next year.
Bond markets investors and traders want to know whether or not the ECB will use those purchases to put downward pressure on longer term interest rates. The US Federal Reserve has twice attempted to do so, in the 1960s and at the start of this decade, through its so-called Operation Twist, which involved buying bonds with longer maturities.
Another sensitive issue is whether a newly-revamped capital key — a statistical calculation used by the ECB to calculate how many of each member states’ bonds it buys — will mean fewer purchases of Italian debt, and more of German government paper.
The bank is also debating how much to spell out what will happen to interest rates not only next year, but over the course of the economic cycle.
Benoît Cœuré, an executive board member and potential successor to Mr Draghi, has said policymakers should do more to clarify at what pace rates will rise.
But one of his rivals for the post, François Villeroy de Galhau, the Banque de France governor, argues that for now it is better for the central bank to keep its options open, although it may have to rethink this strategy in the summer of 2019 if markets become more volatile.
Brexit and euro clearing
Uncertainty about Brexit is on the rise, and so, it seems is the risk of a no-deal UK exit. With the clock ticking before the country’s scheduled March 29 departure from the EU, two recent EU summits failed to make progress on the withdrawal treaty.
So far the ECB has said little about the economic consequences of Brexit and has appeared reluctant to become embroiled in the politically charged debate.
But it has been working with the Bank of England on one of the big financial risks of a no-deal Brexit: the threat to a huge number of derivatives contracts.
The BoE has said up to £41tn of contracts that mature after Brexit are at risk unless officials urgently address regulatory uncertainty. The ECB has not issued such a stark warning, but Mr Draghi said last month that until a deal is reached banks needed action “to address potential risks.”
The two central banks have been preparing a paper for the European Commission and the UK Treasury on the issue.
Most of the big companies that provide clearing services for euro-denominated derivatives are based in London and the ECB estimates 90 per cent of interest-rate swaps coming from the EU are cleared through London.
But EU rules stipulate that the bloc’s banks can only use authorised clearing houses. Without an exit deal, the clearing houses in London — notably LCH, ICE Clear Europe and LME Clear — would lose this status.
The UK government has said it would authorise European clearing houses, and give temporary permissions that would allow financial companies to continue with their current regulatory authorisations. But no parallel announcement has come from the EU, and the vast majority of European derivatives business is in London.
With Brexit talks at an apparent impasse, Mr Draghi could face questions on Thursday on what the ECB thinks about the economic and financial repercussions of a disorderly Brexit on central clearing.
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