”Fragmentation” is relative to financial integration, which means that when a highly integrated financial market is impacted by risk events, the internal differentiation intensifies, and it is divided into different independent markets, and the interest rate levels between different markets are significantly different. Abnormal capital flows, the transmission of monetary policy is blocked, and it is difficult to achieve the expected effect of the policy. This phenomenon is particularly obvious in the euro area.
“Fragmentation” Risk Causes
In 1992, European leaders signed the Maastricht Treaty, announcing the establishment of the European Union, and decided to start using the single currency euro on January 1, 1999, and to implement a unified monetary policy in countries that implement the euro. “Diversity and unity” is an important tenet of the European Union, “plurality” refers to the figurative symbol of each country, and an important symbol of “oneness” is the use of the euro. The euro brings EU countries closer together, but “diversity” also brings many challenges.
On January 1, 1999, the European Central Bank began operations, and the euro was launched at the same time. In 2002, euro cash was officially put into circulation and became the only legal tender in circulation in the euro area. The euro area is also expanding with the development of the euro, from 11 founding members to the current 19. Croatia is about to join the euro area on January 1, 2023, when the euro area will expand to 20 countries. Each member state has its own economic structure, political structure, social governance method, energy structure and fiscal policy, which reflects the “diversity” of the euro area, but under the impact of risk events, each member state is affected in various ways In the same way, “diversification” has created the risk of “fragmentation” of the euro area under “integration”.
The differentiation of economic fundamentals is an important factor in “fragmentation”. The “diversity” of euro area countries is reflected in many aspects, among which the intensified differentiation of economic fundamentals is an important factor affecting the risk of “fragmentation”. In the current context, this fundamental differentiation is reflected in the following three aspects:
First, the fiscal and balance of payments status of the member states of the euro area are quite different. The financial situation of the countries in the euro area is quite different, especially the gap between the northern and southern European countries is obvious. Among them, Luxembourg, Estonia and Lithuania and other countries have better financial conditions, the general government debt to GDP ratio is less than 50%, and the general government deficit to GDP ratio is less than 3. %, while Greece, Italy, Spain and France are above 100% and 5% respectively. Due to differences in economic structure and other reasons, the balance of payments within the euro area is very different. Among them, Germany, the Netherlands, Ireland and other countries have large-scale trade surpluses, and the current account balance accounts for a relatively high proportion of GDP. However, Greece, Spain, and Portugal have large trade deficits, and the current account deficit of Greece and other countries accounts for more than 5% of GDP. The poor fiscal and international balance of payments have made Greece, Italy, Spain and other southern European countries the weakest link in the euro area.
Figure 1: Fiscal Situation of Eurozone Member States
Source: Eurostat, World Bank
Figure 2: Balance of Payments of Eurozone Member States
Source: Eurostat, World Bank
Figure 3: Inflation Levels of Eurozone Member States in June
Data source: Eurostat
Figure 4: Economic Growth of Eurozone Member States 2021-2023
Data source: European Central Bank
Second, the difference in energy structure makes the inflation of the euro zone serious. The global energy supply is in short supply, and Europe’s energy supply relies on pipeline natural gas delivered by Russia. The Russian-Ukrainian conflict has exacerbated the tension in Europe’s energy supply, leading to soaring energy prices in Europe and pushing up inflation in the euro zone to new highs, forcing the European Central Bank to accelerate monetary policy tightening. However, the energy structure of countries in the euro area is not the same, resulting in large differences in the level of inflation among countries. More than 70% of France’s energy comes from nuclear energy, and energy prices have little impact on French inflation. In June, the French CPI rose by 6.5% year-on-year, only higher than Malta’s 6.1%. The Baltic countries and other Eastern European countries are highly dependent on Russia’s energy, and inflation has risen sharply. Among them, Estonia’s CPI in June rose by 22% year-on-year, the highest in the euro area.
Third, risk events have exacerbated the divergence of economic fundamentals among member countries. Since 2020, under the major risk events such as the new crown pneumonia epidemic and the Russian-Ukrainian conflict, the economies of the countries in the euro area have been severely impacted, but the degree of impact, the speed and strength of economic recovery have been significantly different, resulting in nearly three Over the past few years, the economic fundamentals of countries in the euro area have continued to diverge, exacerbating the imbalance of the euro area’s internal economy.
Countries in the euro area are faced with rising inflation of different magnitudes, economic slowdowns of different degrees, and different stagflation risks. However, the coordination of fiscal policy is hesitant and the policy response is slow, which often makes the imbalance more serious and the risk of “fragmentation”. more prominent.
The mechanism of action of “fragmentation”
As a currency union composed of sovereign states, the euro area has different national bond yields due to the discretionary power of economic policies and fiscal budgets of each member state. According to the asset pricing theory, the yield of a country’s national debt is determined by the country’s willingness to pay its debts and its ability to pay its debts. There are significant differences in the economic growth, inflation level, general government debt to GDP ratio, deficit scale and GDP ratio, and international balance of payments. , the market has different expectations for the debt repayment of various countries, and there are differences in the hedging of treasury bond yields. Since the yield of treasury bonds is the pricing basis of other assets, the difference in yield makes the interest rate level vary from country to country.
Under normal conditions, such differences in funding conditions would not threaten financial stability, but they would increase the gap between economic fundamentals and the interest rate environment, complicating the transmission of monetary policy. However, when risk events such as the international financial crisis, the new crown pneumonia epidemic and the Russian-Ukrainian conflict occurred, the market epidemic situation changed dramatically, the yield of national debt quickly deviates from the economic fundamentals, and the impact of risk events on various countries is not the same, resulting in national debt of various countries. Yields are faced with re-valuation of risks, coupled with the existing “disparity” between economic fundamentals and interest rate levels in various countries, the balance of the euro zone financial market is rapidly fragmented, the spread of national bond yields has widened, and financial “fragmentation” occurs.
In addition, when a risk event occurs in one member state of the euro area, due to the contagiousness of financial risks, it will exert financial pressure on other countries, and may develop into a systemic crisis in the euro area, such as the European crisis, the crisis from Greece Contagion to Ireland, Portugal and other countries, and then have an impact on the entire euro area. The eurozone-specific fragility reflects an inherent feature of single-currency regions: Investors can easily rebalance funds across countries without taking on foreign exchange risk, which makes destabilizing capital flows more likely.
The Eurozone’s response to the symptoms rather than the root causes
In order to avoid the risk of “fragmentation”, the European Union’s Stability and Growth Pact added a ban on monetary financing by the European Central Bank, aiming to ensure that governments pursue sound fiscal policies. In the face of a crisis, treaty rules do not ensure the stability of the euro area, and the European Central Bank must respond under the crisis to avoid the risk of “fragmentation” threatening the stability of the euro area.
In 2010, when the market began to realize the seriousness of Greece’s debt problem, Greek government bonds sold off and yields began to climb. At that time, the aftermath of the international financial crisis had not been eliminated, the risk tolerance of investors had not yet been repaired, and the risk of Greek sovereign debt had gradually evolved into concerns about the survival of the euro area, and the contagion of financial risks had thus formed. The market’s sell-off of bonds spread from Greece to Ireland, Portugal and other highly indebted countries, and finally spread to more euro area countries, resulting in a rapid expansion of interest rate spreads in euro area countries. The liquidity crisis turned into a debt service crisis, and the European crisis erupted.
The European Financial Stability Mechanism (EFSM), the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM), the International Monetary Fund (IMF) and the European Central Bank (ECB) form the “Bailout Triangle”. Among them, the European Central Bank has played an important role in solving the problem of financial fragmentation through the Securities Market Program (SMP), Covered Bond Purchase Program (CBPP) and Very Long-Term Refinancing Operations (VLTROs). to rebuild market confidence. In September 2012, the European Central Bank announced the launch of the Outright Currency Trading Program (OMT), which plans to directly purchase national debt of member states in the secondary market. On the one hand, it demonstrates its firm commitment to restoring the financing function of the bond market; Ensuring that the ECB is not influenced by fiscal policy maintains its independence. Although OMT has not been activated, it demonstrates the policy determination of the European Central Bank, dispels market concerns about its independence and disintegration, and restores market confidence. .
In March 2022, the new crown pneumonia epidemic had an impact on the euro area. The European Central Bank quickly launched a rescue package. Among them, the flexibility of the emergency anti-epidemic bond purchase program (PEPP) allows the European Central Bank to provide the most needy countries and most need liquidity. The market provides the most timely liquidity. PEPP tilted towards member states such as Italy, Spain, Portugal, and the more vulnerable Greece that were most affected by the epidemic at the time, and the European Central Bank injected liquidity into the bond markets of these countries.
Figure 5: Yield spread between some countries and Germany’s 10-year bond during the European debt crisis
Data source: Eurostat
The flexible operation of PEPP solved the liquidity crisis, quickly stabilized the market, and restored market confidence. The bond yield spread among euro zone member countries quickly returned, and the fragmentation phenomenon was brought under control.
At present, the euro zone economy has not fully recovered from the new crown pneumonia epidemic, and the outbreak of the Russian-Ukrainian conflict has further affected the euro zone economy for a long time. Since the European Central Bank announced the end of the net purchase of PEPP assets, the outbreak of the Russian-Ukrainian conflict and the political turmoil in Italy further exacerbated the risk of fragmentation. In response to a potential crisis, the ECB’s response measures are focused on: first, give full play to the flexibility of the PEPP, and use the mature funds before the end of 2024 to purchase the national debt of member states whose financing environment has deteriorated, so as to quell the widening trend of interest rate spreads. The second is to launch a new tool, the Transmission Protection Mechanism (TPI), to directly purchase bonds issued by member countries with deteriorating financing conditions in the secondary market. The purchase scale depends on the severity of fragmentation.
PEPP reinvestment and TPI are the ECB’s monetary policy measures to address financial fragmentation. As mentioned above, the fundamental cause of fragmentation comes from the fundamental differences among member states. The key to solving the problem is to adjust economic policies to reduce the fundamental differences among member states, establish a risk sharing mechanism, and consolidate the euro area. integration to reduce fragmentation.
The Next Generation EU Plan (NGEU) starts with fiscal policy to help member states recover quickly from the crisis. The NGEU, through the Recovery and Recovery Fund (RRF), tilts towards countries with low GDP per capita and higher general public debt ratios, addresses the problem of increasing differences in economic fundamentals, promotes the convergence of the euro area, and promotes the euro while respecting “diversity” “integration” of the district.
All in all, “diversity and unity” is the most typical feature of the euro area, but it also brings many challenges to policymakers, and the risk of financial “fragmentation” is one of them. The European Central Bank’s monetary policy response measures can only help reduce these risks. The key to solving the problem lies in the coordination of national economic policies, especially fiscal policies. It is necessary to establish a fiscal sharing mechanism to eliminate the risk of “fragmentation”. With the tightening of monetary policy by the European Central Bank, the risk of “stagflation” in the euro area economy will increase, and the risk of “fragmentation” in the euro area will become more significant. In the short term, we will pay attention to the details of the ECB’s TPI policy tools and long-term attention to the improvement process of the institutional framework of the euro area.