A Legal and Economic Analysis of The ECB Transmission Protection Instrument

The ECB Transmission Protection Instrument: A Legal & Economic Analysis Presented by: Kerstin Bernoth, Sara Dietz, Gökhan Ider and Rosa Lastra Date: October 31, 2022 Introduction In the light of the announcement of the new Transmission Protection Instrument (TP announced in July 2022, important questions need to be asked: 1. Is TPI in conformity with the provisions of the TEU and TFEU and in particular the prohibition of monetary financing (Art. 123 TFEU)? - Legal Framework and Legal Analysis 2. What are the differences between TPI and the Outright Monetary Transaction Program (OMT) which has been announced in 2012? 3. Is the currently observed increase in bond yields linked to country-specific fundamentals or is the disruption based on market failure? - Economic Analysis Analysis of TPI from Legal Perspective - The provisions in the Treaty and the ESCB Statute that refer to monetary policy (Art. 127 TFEU, Art. 18 of ESCB Statute) are formulated in broad terms to provide an enabling legal basis for an expanding range of "unconventional" monetary policy instruments. - But the Treaty is also clear in delineating what the ECB cannot do, and it does so in relatively precise and narrow terms. The provisions that refer to monetary financing (Art. 123 TFEU) and the so-called no bail-out policy (Art. 125 TFEU) establish clear legal prohibitions, in line with the different jurisdictional domains of monetary policy (centralized, ECB responsibility) and fiscal policy (decentralized, national responsibility). The principle of independence, the principle of democracy and the EU principles of conferral, subsidiarity, and proportionality as well as the principle of institutional balance constitute firm limits for the ECB. - TPI entails some features and parameters that raise concerns from a legal perspective. 1. Competence - price stability mandate and monetary policy transmission:  Singleness of monetary policy and monetary policy transmission part of ECB's mandate, but itself not sufficient to prove compatibility with mandate:  ECB needs to prove that financial fragmentation due to sovereign bond yield spreads may not be warranted by country-specific fundamentals 2. Eligibility/Conditionality:  Activation of TPI requires sound and sustainable fiscal and macroeconomic policies and lists four eligibility criteria which are considered in the assessment.  ECB not suited to make this judgment - endanger its independence. 3. Monetary Financing:  The ECB needs to substantiate the parameters of the TPI to make sure that they fulfill requirements established by ECB in Gauleiter and Weiss with regard to the compatibility of government bond purchases on the secondary market with prohibition of monetary financing (Art. 123 TFEU). 4. Transparency and Accountability:  The terms set out in the Press Release on TPI lack substantiation, justification, and detail in many aspects (esp. with regard to assessment if financial fragmentation is "unwarranted") 5. Risk- and Loss-Sharing:  Risk- and loss-sharing is not addressed in the Press Release; ECB should disclose these important parameters as grounds for accountability and to enable EP to scrutinize and challenge the decision. Comparison between TPI and OMT Selectivity OMT TPI Purchase of government Secondary market purchases bonds of selected Member of securities issued in States which experience high jurisdictions experiencing a yield spreads to safeguard deterioration in financing monetary policy conditions not warranted by OMT transmission TPI country-specific fundamentals, to counter risks to the transmission mechanism to the extent necessary Eligibility/ Conditionality Strict and effective Eligibility criteria to take conditionality attached to an into consideration: appropriate European 1. compliance with the Financial Stability EU fiscal framework Facility/European Stability 2. absence of severe Mechanism (EFSF/ESM) macroeconomic program. imbalances 3. fiscal sustainability 4. sound and sustainable macroeconomic policies Limit on purchases No ex ante quantitative No ex ante quantitative limits limits are set on the size of are set on the size of the the purchases. purchases; volume depends on severity of risks facing monetary policy transmission. Creditor treatment ECB is treated the same as ECB is treated the same as private or other creditorsprivate or other creditors with respect to bonds issuedwith respect to bonds issued by euro area governments. by euro area governments. Purchase parameters Sovereign bonds with a Public sector securities with remaining maturity of 1-3a remaining maturity of 1-10 years years; if appropriate (at the discretion of the ECB), purchases of private sector securities could be considered. Relation to monetary policy Liquidity created through Purchases under the TPI stance OMT is fully sterilized. would be conducted such that they cause no impact on the monetary policy stance; the Governing Council is responsible for addressing the implications of TPI purchases for the aggregate Euro system monetary policy debt security portfolio, the amount of excess liquidity, and Euro system balance sheet. Current Rise in Bond Spreads - Unwarranted? - ECB will activate the TPI if the financing conditions of individual countries deteriorate without being justified by country-specific fundamentals. - The problem is for the ECB itself to determine whether and when this is the case. - In the economic part of our study, we estimate the determinants of sovereign yield spreads, since risk assessment varies significantly over time (Bernoth et al. 2010, 2012). In particular we examine:  To what extent does an observed change in the yield spread reflect a change in markets' pricing of macroeconomic fundamentals or in the fundamentals themselves? At what points in time and has the pricing of the various risk components changed? How large is the unexplained part of the changes in the yield spreads? - Our results show that:  Bond yield spreads are significantly determined by debt ratios and general risk aversion and that most of the spread rise in 2022 can be attributed to a deterioration in macroeconomic fundamentals, in particular the debt-toGDP ratio.  No overreaction apparent yet. It seems to be more a normalization. Therefore we conclude that the activation of TPI is not necessary yet.  This was not the case in 2012 during European debt crisis, where Greek bonds where more than 20% higher than the model predicted. Therefore the OMT announcement in 2012 was reasonable. Conclusion  Our economic analysis shows that the bond yield spreads are not yet to be qualified as disorderly or unwarranted, decoupled from macroeconomic fundamentals.  Given the legal concerns, the ECB might be well advised to first resort to other measures and actors that are better suited to address challenges of rising yield spreads:  It is the Member State's responsibility to take - unilaterally or more I effectively at the EU level - action to fight rising government debt and economic fall-outs.  It is not for the ECB to compensate for the absence of fiscal integration and to ensure that euro area is not torn apart by diverging economic and fiscal situations of its Member States.