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Analysis-ECB bond aid plan's fault lines exposed by Italy's political crisis

FILE PHOTO: Sun sets over the skyline and ECB headquarters in Frankfurt

By Francesco Canepa

FRANKFURT (Reuters) - A government crisis in Italy is complicating a politically sensitive plan devised by the European Central Bank to support indebted euro zone countries on the bond market before it even starts in earnest.

In an unprecedented effort to cap borrowing costs, the ECB said last month it would buy more of a given state's bonds if its debt yields rose too far in an unwarranted fashion.

The scheme, using the proceeds of the ECB's existing bond holdings as well as a new mechanism to be unveiled next week, was a response to a sudden rise in yields across southern Europe.

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The rise was most acute in Italy, largely due to investors pricing in slower economic growth and the impact of higher interest rates on its 2.5-trillion-euro debt pile.

But the latest surge in Italian bond yields and in the borrowing premium it pays over safe-haven Germany has been harder to interpret, as markets respond to fears of a collapse of Mario Draghi's government, whose fate hangs in the balance.

This leaves the ECB in the awkward position of determining which part of the spread widening is "unwarranted" - or giving up buying Italy's bonds altogether.

That decision has legal implications, as intervening in the middle of a government crisis would provide fresh ammunition to those who have accused the ECB, via its market transactions, of breaking the law by getting involved in politics.

Such criticisms - along with lawsuits challenging a long-running ECB asset purchase scheme - have been prominent in Germany.

Bundesbank President Joachim Nagel has this month fleshed out its latest concerns, saying that determining if a risk premium was justified or not was "virtually impossible", and that market prices should be deemed as fair until proven otherwise.

"The spread widening is the result of the market reassessing the fiscal outlook and the prospect for reforms, so before a new government is known it's difficult to say that it's unwarranted," said Dirk Schumacher, an economist at Natixis.

VOLATILE SPREADS

The ECB is buying bonds from Italy, Spain, Portugal and Greece with some of the proceeds it receives from maturing German, French and Dutch debt in a bid to cap spreads between countries' borrowing costs.

It is also working on a new programme to allow it to buy even more bonds from Southern European countries, using newly minted money that could then be offset by draining liquidity via reverse auctions or certificates of deposits.

In both cases, purchases can only be activated if what the ECB terms financial "fragmentation" between different countries is deemed unjustified.

When the ECB announced its plans on June 15, the closely watched spread between Italian and German 10-year bonds had hit a two-year high of 250 basis points. That helped narrow it to 186.

It is now back around 222 as investors weigh hopes of Draghi - Christine Lagarde's predecessor as ECB president - staying against the risk of new elections, at which polls suggest the far-right Brothers of Italy may emerge as the biggest party.

That also begs the question of what subsequent rises might be considered warranted or not.

"The ECB will not and should not react to what is happening in Italy," said Frederick Ducrozet, an economist at Pictet, adding that it could let the spread rise to 300 basis points without intervening.

STRINGS ATTACHED

The new scheme will come with strings attached, aimed at thwarting fresh legal challenges by showing the courts the ECB is not simply bankrolling indebted governments.

Countries might be expected to comply with the European Commission's economic recommendations and the terms of the European Union's recovery fund, and have their debt deemed sustainable by the ECB, the Commission or the European Stability Mechanism, sources have told Reuters.

In light of the events in Italy, those conditions may prove vital to making the scheme workable.

"They can tell Italy: it's your choice, you're either European or not," Ducrozet said.

With a recession in Europe looming if Russia turns off the gas taps in the autumn, others think the ECB should not play hardball.

"Europe can't afford a new crisis in the current situation," said Carsten Brzeski, an economist at ING.

"This means the ECB will have to sound even more determined to act and it also means easier conditionality on the new tool."

He saw the ECB linking the new scheme to a country sticking to reform plans rather than having the stigma of getting the ESM -created as a bailout fund a decade ago - involved.

In 2018, the ECB stayed put when Italian spreads widened after the formation of what was then seen as a populist, eurosceptic government.

But now, the worries about higher rates and political concerns are harder to disentangle.

(Reporting by Francesco Canepa; editing by John Stonestreet)