Can the European Central Bank’s rating cuts save the eurozone?

The Financial Times said that under Christine Lagarde’s leadership, the European Central Bank (ECB) is the only EU institution that can ‘save the eurozone’ in the midst of the economic impact that the coronavirus is having on Europe’s economy. This is because ECB governors agreed during a meeting on Wednesday that banks could put up ‘junk’ bonds as collateral when borrowing from the central bank, in case firms and eurozone governments witness their credit ratings downgraded.

Italian debt could slide toward ‘junk status’

The ECB is now offering banks access to substantial amounts of cash via low interest loans on top of its $1.2 trillion ‘quantitative easing’ bond program with the aim of ensuring credit travels to the real economy to sustain the damage of a financial blow caused by lockdowns.

In order to access liquidity, banks must still put up collateral, which is often government or other debt on their books. If government or other debt is labeled as ‘junk’, that means it could not be classed as collateral. This will hinder banks’ ability to continue lending and disrupt their economic activity by forcing them to sell the debt.

The country that would be most affected by the ECB’s latest moves would be Italy. According to France 24, ING analysts wrote ahead of a telephone conference late Wednesday that junk bonds ‘have Italy written all over them.’ Experts believe that Italian debt could slide toward junk status.

Covid-19 is testing the limits of the bloc’s solidarity

The ECB’s decision has helped maintain short-term financial stability by keeping consumer prices on an even keel. The central bank’s bond holdings are on track to total around $4 trillion by December, approximately a third of the eurozone’s GDP. This will help cover the €1.5 trillion of additional government spending that will be necessary to fight the upcoming recession.

As Bloomberg’s Piotr Skolimowski argues, what makes the eurozone unique is that the 19 member states are not part of a fiscal union and Covid-19 is testing the limits of the bloc’s solidarity.

Gilles Moec, chief economist at AXA in London and former Bank of France official, believes the ECB could resort to ‘slow debt monetization’, and says that the central bank could even buy the loans made by banks to businesses and repackage them into 30-year loans with a zero percent interest rate. The idea is that if loan repayments are extended over a period of thirty years as opposed to three years, then the debt is more than likely to be paid back.

Italy will lose out in the longer term

The ECB has a couple of options to curb the economic effects Covid-19 is having on Europe’s economy, but the choices it makes to rescue the eurozone will damage Italy’s economic prospects in the future. The central bank’s suspension of its own fiscal rules means that the indebted Mediterranean nations will have to repay their debt at some point. Italy’s debt-to-GDP ratio could exceed 160 percent, estimates Goldman Sachs. Italy is likely to experience classic debt trap dynamics in the future once the ECB’s assistance stops. This means that the Italians would be unlikely to refinance their expanding debt.

Italian journalist Thomas Fazi said three options are left for his country if that happens: it quits the euro, accepts the European Stability Mechanism’s austerity program that could lead to decades of austerity, or Italy’s debt is monetized. For the Italians, any path that the ECB follows may provide short-term relief but long-term pain for a nation that has already experienced over a decade of austerity following the 2008 financial crisis.

Lagarde may be doing everything she can to rescue the eurozone for now, but her policies will be financially damaging for the southern European states. Once she ends her suspension of the ECB’s rules, Italy will come out of this crisis worse than other EU member states.