Published on 4 August 2022

Two countries are currently in the European Exchange Rate Mechanism II – Bulgaria and Croatia. ERM II is the Euro waiting room. Croatia has now passed the tests to get on the plane – but should it pause and apply some tests to the Euro itself?

We recently ran some tests on the situation of its partner in the waiting room – Bulgaria. By joining the euro now, the Bulgarian National Bank (BNB) would become part of the loss-sharing mechanism on ECB programmes in line with its ECB Capital Key of 1% (0.9832%): the ECB’s programmes total €8.9 trillion (the €5.7 trillion in Figure 1 below plus €3.2 trillion in the ECB’s Asset Purchase Programmes), so the BNB would become potentially liable for up to €89 billion, compared to Bulgaria’s GDP of €68 billion.

The risk of the potential liability materializing into a real one has risen dramatically: ECB bond-buying programmes will already be showing losses on ‘Club Med’ government bonds, where yields have risen from 1% to 4%, and the spread against German government bonds has widened to 2 1/2 – 3%.

The ECB is caught in an impossible position in having to decide between two courses of action, either of which could be disastrous to both the euro project and the Eurozone member states: the choices are
(i) to follow the Fed by raising interest rates and by reducing the Eurosystem balance sheet; or (ii) to make only minimal increases in interest rates and to re-start major bond buying into the APP now that
it has stopped new purchases into the PEPP. (i) will be disastrous for Eurozone member state budgets and will bring about another Eurozone sovereign debt crisis; (ii) risks the credibility of the euro project and a legal challenge to the ECB’s mandate for failing to control inflation. Any course of action by the ECB raises the risk of the potential liability on ECB programmes materializing into a real one.

Here are the outstanding amounts as per 31 December 2021 of the programmes quoted in it:

Programme2021 in € billions2020 in € billions
Pandemic Emergency Purchase Programme€1,696€840
Targeted Longer-term Refinancing Operations€2,202€1,793
TARGET2 net-net balance on ECB balance sheet€335€336
TARGET2 net balance off ECB balance sheet€1,457€1,285
 €5,690€4,254
Figure 1 – amounts in ECB programmes other than the Asset Purchase Programmes

The TARGET2 figures above are derived from the netting by the ECB of its aggregate positions against each National Central Bank. These aggregate positions are given in the table below, but the underlying information is not in the public domain: (i) the original balances on the NCBs’ and ECB’s accounts held amongst themselves at the end of the processing day; (ii) the summation of the two balances of each pair of NCBs with one another on vostro and nostro during the end-of-day process; (iii) how the figures below derive from (ii) above.

Borrower NCBs€ billionsDepositor NCBs€ billions
Belgium85.7Germany1,260.7
Greece104.2 Estonia0.6
Spain512.8 Ireland84.8
Italy590.0 France25.8
Latvia5.3 Cyprus12.6
Netherlands22.5Lithuania14.9
Austria57.4Luxembourg326.6
Portugal79.3 Malta7.3
  Slovenia9.2
 Slovakia23.9
  Finland25.3
  Non-Eurozone5.8
 1,457.2 1,791.8
Matching Balance1,457.2Off ECB balance sheet
Mismatch334.6
Imbalance334.6On ECB balance sheet
Figure 2 – TARGET2 balances at the end of 2021

There is also a new programme mobilised through the EIB Group and backed via the European Guarantee Fund, as well as the ongoing InvestEU programme, also mobilised through the EIB Group but backed by an EU guarantee. The amounts of InvestEU funding needed to be calculated as they are not directly disclosed, and our calculations are below for the end of 2021:

ProgrammeAmount in € billions
InvestEU€612
European Guarantee Fund€174
 €786
Figure 3 – amounts outstanding under EIB Group off-balance sheet schemes

The European Guarantee Fund is now closed, but InvestEU is taking off again, thanks to a new EU guarantee for the 2021-7 Multiannual Financial Framework of €26.2 billion.

This is a position that has deteriorated markedly over the preceding 16 months, and now we have inflation, widening bond spreads between German and Italian government bonds, and an ECB that plans, belatedly, to raise interest rates and taper off its bond buying. The tapering-off is announced as a cessation of buying into the Pandemic Emergency Purchase Programme – except for reinvestment of maturities, the monthly size of which has not been disclosed. At the same time there has been no statement as to the fate of the ECB’s pre-existing Asset Purchase Programmes, whose portfolio in April 2022 was €3.2 trillion.

Notwithstanding the worsening external circumstances, the recent announcement of Croatia meeting its euro eligibility tests will now, no doubt, result in renewed pressure on Bulgaria to adopt the euro.