May 18, 2018 / 10:22 AM / in a month

Italian debt held by the ECB in focus as populists sign governing pact

FRANKFURT (Reuters) - Italian financial markets were jolted this week by reports the country’s incoming coalition government wanted to review the accounting status of Italy’s sovereign bonds held by the European Central Bank, possibly even writing this debt off.

Even though the formal coalition agreement did not include such a plan, it has raised questions about the future of sovereign debt held by the ECB and whether it could be treated differently to other bonds.

Euro zone countries must continuously reduce government debt as long as it is above 60 percent of GDP. Only a handful of countries meet this criteria now and the euro zone average is almost 87 percent, with projections showing it above 60 percent for more than a decade.

WHAT BONDS DOES THE ECB HOLD?

The ECB has so far bought 2.4 trillion euros worth of debt as part of its quantitative easing scheme and this sum will hit 2.55 trillion by the end of September, when the program is scheduled to expire.

About 1.8 trillion euros is in sovereign debt, purchased in proportion to each country’s relative size. The rest of the bonds are corporate debt, supranational bonds, covered bonds and asset backed securities.

HOW MUCH ITALIAN DEBT DOES THE ECB HOLD?

At the end of April, the ECB held 341 billion euros worth of Italian sovereign debt with an average remaining maturity of almost eight years. This figure could rise by roughly 3.5 billion euros a month, based on ECB purchases totaling 30 billion euros per month.

This compares to Italy’s gross government debt of 2.26 trillion euros at the end of last year. As a percentage of GDP, this is 132 percent, the second highest in the euro zone after Greece.

WHAT DOES THE ECB DO WITH THESE BONDS?

The ECB holds the bonds until they mature and then reinvests the cash back into debt issued by the same country, though with some flexibility about the timing of the new purchase and the type of the new bond.

At some point in the future, the ECB may decide to shrink its balance sheet but the first step is likely to be a decision to stop reinvesting maturing debt. Any outright sale of bonds is years into the future.

Redemptions will be sizable. They will total 173 billion euros over the coming 12 months with 141 billion euros of this in public sector bonds.

WHY COULD THE ECB NOT CANCEL THIS DEBT?

Simply put: that would be illegal. The ECB is barred by law from providing financing to governments. It is also independent and can’t be instructed by governments on what to do with bonds it purchased.

BUT ISN’T THE ECB ALREADY PROVIDING FINANCING?

It’s a fine line and some, particularly in Germany, have challenged the ECB over this. Since the ECB can buy no more than one-third of a country’s bonds, this is accepted as a monetary policy tool aimed at reducing the term premia, or the premium investors demand to hold longer dated debt over shorter papers. The ECB’s scheme is similar to debt purchase programmes carried out by the U.S. Federal Reserve, the Bank of Japan and the Bank of England.

Governments are still required to service their debt and the ECB has made sizable profits on the purchases so far. But this profit is then paid out to national central banks who frequently pay it into their government budgets. So some of the cash does make it back to state budgets and governments also benefit from lower borrowing costs.

The ECB also has a function to relieve bond market stress when it deems that market prices are a reflection of liquidity stress rather than fundamentals.

Reporting by Balazs Koranyi; Editing by Jon Boyle

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