Why the ECB Is Wary of Stepping Into France’s Bond Turmoil

A sudden selloff of French bonds has stirred memories of the sovereign debt crisis that cascaded across Europe between 2009 and 2015. Attention is now turning to how the European Central Bank might respond.

France has been running one of the euro area’s largest budget deficits. The extra yield demanded by investors to hold French 10-year bonds compared with those of Germany recently hit its highest since 2011. The bonds of other indebted European nations including Italy, Greece and Belgium have also come under pressure.

This suggests investors see a growing risk of “contagion,” in which a loss of confidence in one country’s finances causes the bonds of other nations to slump, too.

To address this, the ECB has two bond-buying mechanisms at its disposal. Of these, it’s the newer, more flexible Transmission Protection Instrument — devised in 2022 to “counter unwarranted, disorderly market dynamics” — that’s drawing most attention.

For the moment, policymakers including ECB President Christine Lagarde and Bank of France chief Emmanuel Moulin say there’s no need to act.

What’s happening in France?

Many euro-area nations, including France, failed to quickly close their deficits in the aftermath of the 2009 debt blowup. Later, they borrowed even more to support populations through the coronavirus pandemic. Since then, a sustained period of higher inflation has increased the cost of servicing national debts. Many governments are trying to rein in their debts, but voters are being squeezed by high living costs and are hostile to spending cuts and tax increases.

Successive French governments have fallen after failing to get belt-tightening budgets approved by a divided and polarized parliament. Investors have been losing patience, and France now has higher borrowing costs than Italy. The government’s proposed 2027 budget is broadly in line with European Union fiscal rules designed to ensure spending and public debt are sustainable. But there’s a risk that it will miss its deficit targets if there’s another government collapse.

The prospect of a presidential election in April next year adds to the uncertainty. President Emmanuel Macron cannot run for office again, and two of the leading candidates to replace him are promising a decisive break with his centrist agenda. Far-right leader Marine Le Pen has pledged to drastically reduce the deficit, but her party has no experience of national government and economists say her plans lack credibility. She has also called on the ECB to intervene to help bring down France’s borrowing costs. Leftist Jean-Luc Mélenchon has proposed to tackle France’s debt mountain by canceling a portion of what is held by the Bank of France and the ECB.

Why would the ECB get involved?

The ECB needs its monetary policy to be transmitted smoothly across all 21 countries sharing the euro currency. That doesn’t mean governments should face the same borrowing costs: Differences in inflation, economic growth and public debt should be reflected in bond yields.

The concern is instead about market moves that are too rapid or can’t be justified by economic fundamentals — particularly when bond turmoil spreads from one country to others. Such fragmentation can interfere with the ECB’s ability to steer financing conditions across the currency bloc.

That’s what Europe experienced during the sovereign-debt crisis of the 2010s, when trouble that began in Greece infected much of the region’s southern periphery. Concerns resurfaced in 2022 as the ECB prepared to raise interest rates and investors focused on highly indebted countries such as Italy. That year, the ECB devised its TPI bond-buying tool.

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How would the TPI work?

The idea would be to intervene temporarily in the market to support the price of a nation’s bonds during a sudden selloff. The ECB says the TPI can be activated to “counter unwarranted, disorderly market dynamics” that threaten the transmission of monetary policy. The central bank would effectively print money and use it to buy up bonds being dumped by investors. There would be no preset spending limit, and some aspects of the TPI have been deliberately left vague so the central bank could react flexibly to whatever crisis it might be facing.

Actually using the TPI would be a major step, and would remove some of the mystery that may have contributed to its deterrent power. The ECB never needed to deploy it in 2022, and it has remained on the shelf ever since.

Before reaching for the TPI, policymakers would probably try to calm markets verbally and urge the affected country to address its fiscal problems.

What are the downsides of the TPI?

For one thing, it would inject a potentially significant amount of money into the euro-zone economy just when inflation is overshooting the ECB’s target of 2% and interest rates are on the rise. So ECB officials would need to consider the inflationary impact of the TPI and ways to mitigate it.

They’d also need to think about the market optics. The ECB is there to be an arbiter of the financial system, not a player. It doesn’t want to be seen propping up fiscally irresponsible governments as a kind of lender of last resort.

For that reason, the ECB would only make TPI purchases if the country concerned is complying with the bloc’s fiscal framework. That means its public debt must be sustainable and its government should be following sound economic policies.

So could the ECB really use the TPI to help France?

France is a difficult case. Its market troubles are rooted at least partly in its own fiscal and political problems — precisely the kind of issues the ECB isn’t there to fix.

The TPI could become easier to justify if policymakers conclude that a selloff is intensifying and market moves elsewhere are becoming increasingly detached from economic fundamentals.

French officials have said the situation is nowhere near the point at which ECB intervention is warranted. Bank of France Governor Moulin said the conditions for ECB action aren’t currently met, and that “the ECB is not there to deal with the fiscal problems of countries.” He argued that the solution lies with France itself: passing a budget and committing to keep the deficit below 5% of gross domestic product.

Other ECB policymakers have said higher borrowing costs alone don’t warrant intervention. German Bundesbank President Joachim Nagel said the ECB’s bond-buying tools aren’t designed to defend particular “spread” levels. Another ECB Governing Council member, Finland’s Olli Rehn, said there’s currently no reason to deploy the ECB’s safety net for France.

Is TPI the only tool available?

No. The ECB also has the Outright Monetary Transactions plan, a bond-buying program created in 2012 after its then-President Mario Draghi vowed to do “whatever it takes” to preserve the euro. OMT has also never been used.

It’s a narrower tool than TPI and carries much more stringent requirements. A country must be part of a European rescue program with policy conditions, making OMT better suited to a full-blown sovereign-debt crisis than simply containing disorderly markets.