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A new euro crisis looming now?

Experts such as Ulrich Kater, chief economist at Dekabank, classify the market situation as “not dramatic”. “The emergency meeting of the Governing Council was therefore more of a preventive nature,” Kater said Wednesday. So the experts are divided, but what happened in the first place?

ECB raises interest rates

In view of the steep rise in inflation, the ECB announced the first interest rate hike in eleven years last week in July. The ECB announced Thursday that it intends to raise the rate by 0.25 percentage points. This is expected to follow in September, even more so than in July if inflation remains high.

As an important prerequisite for this, it announced the end of the APP multi-billion dollar bond purchase program – on July 1, 2022. Capital market interest rates also rose, particularly for Southern European government bonds. States finance themselves with these bonds (read more about this here).

The so-called spread between German government bonds and the government bonds of the most heavily indebted euro countries in the south, such as Italy, has recently widened. On Tuesday, the yield spread had increased to over 2.50 percentage points, the widest since 2020.

Some euro states may have funding problems

This yield spread, also known as the risk premium, reflects investors’ fears that the ECB could lose sight of the special needs of the southern countries if it tightened monetary policy and raised interest rates. The problem for highly indebted countries: It is becoming more expensive to finance and obtain fresh money.

This can lead to a threatening downward spiral. This is because highly indebted countries, in particular, are replacing the debt of previous bonds with new bonds. If the costs of government bonds now rise, these countries risk having a hard time paying off their previous debts. This very development put Greece in a dangerous imbalance ten years ago.

ECB director Isabel Schnabel had therefore already stated on Tuesday that monetary policy would have to react if the risk premia on the bond market had skyrocketed and this would undermine price stability and the measures taken by the central bank.

The latest peaks bring to mind the euro debt crisis of ten years ago. At that time, financial markets could only calm down when then ECB chief Mario Draghi promised that the central bank would do everything possible to save the euro. The expression “whatever it takes” has gone down in financial history. Already now, the ECB wanted to prevent capital market interest rates from rising further (see next section).

What is the ECB doing?

He sees the problem and announced he would take countermeasures at his special meeting on Wednesday. “The pandemic has left lasting vulnerabilities in the euro area economy, which are effectively contributing to an uneven transmission of the normalization of our monetary policy to individual countries,” the central bank said in a statement. To put it clearly: the announced turnaround in interest rates is already having different effects on individual euro states.

Among other things, monetary observers have decided that money from the recently concluded PEPP crisis bond purchase program worth billions should flow into new government bonds of high-debt euro-zone countries, such as the Italy or Greece. According to the central bank, these countries should now be given more consideration in the next reinvestment of funds. The ECB will allow “flexibility” to prevail here.

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