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The European Central Bank is trying to avoid a sovereign-debt storm after raising interest rates for the first time since 2011. It’s concerned about how markets might push up borrowing costs for some of the more vulnerable nations that use the euro — such as Italy. That sort of potential blowup in government bond yields is known as “fragmentation.” So the ECB has devised a new weapon to curb market stress, a signal of its determination to fight the forces that almost destroyed the common currency a decade ago.

1. What’s meant by ‘fragmentation’?

The term refers to a jump in borrowing costs for weaker euro-zone countries relative to stronger ones. While the currency bloc’s 19 economies differ by metrics like inflation, economic growth and debt, policy makers say some market moves don’t reflect these fundamentals and are too rapid. The states with the highest ratios of debt to gross domestic product — notably Greece and Italy — had some of the highest bond yields among major nations in June. The effort gained urgency after the yield on 10-year Italian bonds breached 4%, the highest since 2014. What’s more, the difference in yield, or spread, above Germany, the continent’s benchmark, had widened. Making matters worse is a collapse of the government in Italy, which could test the ECB’s resolve.  

2. Why is that a recurring problem for the euro area?

While euro members share a common currency, they implement their own tax and spending policies, leading to divergences that can swell over time, even with European Union limits on budget deficits. That’s a unique challenge for the ECB, which joined its peers around the world in buying government bonds to support a recovery after the 2008 global financial crisis. The EU’s founding treaties prohibit the ECB from financing member governments, and broad buying of bonds tests that idea. Germany’s Bundesbank, the central bank that provided the blueprint for the ECB, has historically spoken out about the dangers of such moves. 

3. What does the new tool look like? 

The backstop — dubbed the Transmission Protection Instrument — is a new bond-buying tool that is essentially unlimited in nature, with some aspects left deliberately vague. It will be “activated to counter unwarranted, disorderly market dynamics,” the ECB said in a statement unveiling the TPI on July 21. 

Read more: Here’s a Closer Look at the ECB’s New Anti-Fragmentation Tool

4. What conditions are included? 

All euro-area members are eligible provided they comply with EU budget rules and have a level of government debt that’s sustainable. As the ECB raises rates, that borrowing becomes a heavier burden. The mechanism is designed not to interfere with other monetary policy steps, suggesting bond purchases will be offset. 

5. Is the new tool the only thing the ECB is doing? 

No. The ECB has also remodeled its pandemic-era asset-purchase program so it can use reinvestments of maturing debt more flexibly. Officials have opted against imposing strict targets for thresholds for these operations, people familiar with the matter have said. Redirecting the proceeds of core countries’ expiring debt to struggling markets may be enough to keep speculators at bay for now. 

6. What ‘crisis tools’ have been deployed in the past?

Most famously, there was Mario Draghi’s Outright Monetary Transactions program, a bond-buying initiative that was never actually called upon after markets took the former ECB president at his word when he vowed in 2012 to do “whatever it takes” to keep the euro intact. His promise calmed a panic touched off in 2009, after Greece came clean about its budget deficit and borrowing costs soared. That crisis led to bailouts for Greece, Ireland, Portugal and Cyprus plus a rescue of banks in Spain. More recently came the ECB’s Pandemic Emergency Purchase Program, another bond-buying push that was drawn up in a matter of days as Covid-19 swept across the continent in 2020. PEPP, as it’s known, ended up reaching about 1.7 trillion euros ($1.7 trillion) before net purchases were halted in March. 

7. What are the challenges? 

Politics and courts. At the ECB, not everyone’s equally keen to throw a lifeline to countries they deem as fiscally irresponsible. That could make it complicated to agree quickly on whether to activate the measure. The legality of the tool will also be questioned — so far, every one of the ECB’s bond-buying programs has provoked lawsuits.

More stories like this are available on bloomberg.com

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