On May 5, 2020, after an extensive judicial review, the German Constitutional Court ruled that the German federal government and Bundestag had failed to take suitable steps to challenge the European Central Bank's (ECB's) Public Sector Purchase Programme (PSPP) to ensure that it was in line with the EU legal principle of proportionality. The German court also found that the Governing Council of the ECB "neither assessed nor substantiated that the measures provided for in these decisions satisfy the principle of proportionality".

The PSPP was launched in March 2015 as part of the ECB's quantitative easing (QE) policy. The German court ruling states that a program adopted by the ECB "for the purchase of government bonds, such as the PSPP, that has significant economic policy effects must satisfy the principle of proportionality" and must ensure that its "monetary policy objective and its economic policy effects be identified, weighed, and balanced against one another". However, it also concludes that "the PSPP's monetary policy objective is in principle not (yet) objectionable".

The ruling relates to government debt bought by the ECB since 2015 under the PSPP, but not to purchases under the newly created Pandemic Emergency Purchase Programme (PEPP), a temporary public and private asset purchase program created in response to the COVID-19 pandemic, set to expire at the end of 2020.

Inflation-targeting central banks, such as the ECB, purchase government securities in secondary markets to influence financial conditions in both the public and private sector as a means of complying with their price stability mandate. Because there is no substantial single central fiscal authority in the eurozone comparable to those in older monetary unions such as the U.S., the U.K., or Japan, there is no single public debt instrument such as U.S. treasuries or gilts that the ECB can purchase under its QE program. As a consequence, the ECB purchases public debt issued by all 19 eurozone governments proportional to member state economies' size and population (as measured in national central banks' shares in ECB capital).

In its decision, the German Constitutional Court ruled that the ECB, by pursuing its monetary policy objective "unconditionally," had disregarded the economic and fiscal policy effects of the PSPP. The German court also determined that the December 2018 judgement of the European Court of Justice, which found the PSPP to be legal under EU law, had not applied the appropriate proportionality test and was therefore "arbitrary", "not comprehensible," and "ultra vires". The court noted that the PSPP benefited some member states more than others by enabling them to refinance public debt "at considerably better conditions than would otherwise be the case," which has given rise "to the risk that necessary consolidation and reform measures will either not be implemented or discontinued." The German Constitutional Court ordered that the national central bank of Germany, the Bundesbank, cease participating in the PSPP program, i.e., cease to purchase German Bunds, unless the proportionality of the program is demonstrated by the ECB.

This decision comes at a complicated time for the European economy, which is experiencing a severe recession in the shadow of the global COVID-19 pandemic. One of S&P Global Ratings' key assumptions for eurozone sovereign ratings is that the ECB is operationally independent in pursuit of its price stability mandate. On March 18, upon the launch of the €750 billion Pandemic Emergency Purchase Programme (PEPP), the Governing Council of the ECB said it would "ensure that all sectors of the economy can benefit from supportive financing conditions that enable them to absorb this shock" and that it is prepared to "increase the size of its asset purchase programs and adjust their composition by as much as necessary and for as long as needed."

The PEPP differs from the PSPP in several respects:

• It is temporary, set to expire at the end of 2020;
• PEPP purchases, while allocated proportional to member state economies' size and population (as measured in national central banks' shares in ECB capital), will be made "in a flexible manner," allowing for "fluctuations in the distribution of purchase flows over time, across asset classes, and among jurisdictions"; and
• The ECB has indicated a willingness to increase the PEPP's size depending upon the severity of the fallout of the pandemic on the eurozone's economy, and its effects on inflation and financial conditions.

By potentially constraining future amendments to current asset purchase programs, including the newly created PEPP, the German Constitutional Court ruling raises the question whether the ruling constrains the ECB's independence. Such efforts by individual member states' judiciaries (in response to plaintiffs) to apparently influence the ECB (which are not permitted under Article 130 of the Treaty of the EU) would, in our opinion, weaken the ECB's capacity to fight the fallout of the pandemic on price stability and financing conditions across the eurozone.

The PSPP Has Lowered Eurozone Governments' Financing Costs

Since the PSPP was launched in March 2015 as part of the ECB's broader quantitative easing policy, the average funding cost of eurozone governments has declined by 96 basis points (bps), to 2.02% as of end-March 2020. In Germany's case, yields are currently less than 0%, even past the 30-year maturity. Nearly all eurozone governments have taken advantage of benign market conditions to term out their debt profile at lower rates. Indeed, over the past five years, the average weighted maturity of government debt has increased by one year to 7.6 years, and in many cases (Austria, Greece, and Ireland) the weighted maturity of public debt exceeds 10 years. Critically for creditworthiness, the current average yield at issuance for every member of the eurozone is far below its average cost of debt. Italy's current average yield of issuance is 0.8%, and Spain's is 0.3%, whereas the average cost of debt for Italy and Spain (across their entire profiles) are at 2.5% and 2.0%, respectively. The large difference between the two implies that the fiscal cost of paying debt is still set to decline, despite surging levels of debt to GDP.

Chart 1

All else being equal, it is far more difficult for governments to lower their debt-to-GDP burdens in the current environment of low inflation. Even if nominal funding costs have dropped by one percentage point since the PSPP was launched in March 2015, inflation remains around 0.4% in the eurozone (as of end-April), or 1.3% excluding energy prices. Indeed, it is the chronic undershooting of inflation that led the ECB to launch quantitative easing five years ago. One important explanation of low inflation in the eurozone is the significant output gap, explained by oversaving and underinvestment, which show up in the form of massive current account surpluses, not least in Germany. It is this savings surplus, more than anything else, that explains past episodes of low inflation and low growth, resulting in negative yields that have become a political issue in Germany, where the household savings rate is the highest in the Western World.

The ECB Is To Continue To Counter Monetary Fragmentation In The Eurozone

We consider the credibility of the ECB to match that of other G7 central banks. This view is anchored by our understanding that Article 130 of the Treaty of the European Union binds all EU institutions, bodies, and the governments of the member states to respect the independence of the ECB as well as of the national central banks, which, together with the ECB, make up the Eurosystem.

We believe that, despite the German Constitutional Court ruling, the ECB will continue to counter monetary fragmentation in all jurisdictions of the euro area via low interest rates, liquidity injection into the banking system, and balance sheet-expanding asset purchases, mindful of the EU Treaty, but with a determination to purchase flexibly. Above all, the ECB is focused on maintaining the flow of credit to eurozone households and companies at low rates to lay the foundations for an early and sustained economic recovery. Europe is an economy intermediated by banks, with monetary transmission taking place largely through commercial lenders, which also hold and purchase considerable stocks of public debt.

Based on our current economic forecasts, we expect the ECB response to this crisis to widen. This could take the form of an extension of the PEPP in scope, size, or duration.

We would also expect the Bundesbank to be in a position to argue for the legality of the PSPP to avoid the precedent of the ECB defending its role under European law in a member state court. Nevertheless, the antipathy of various stakeholders to a prolongation of the PEPP beyond the end of 2020 suggests the ECB may be subject to renewed pressure to downsize its balance sheet as soon as possible. Should economic conditions--in particular nominal GDP and inflation--remain depressed into 2021 and 2022, this could add negative pressure on eurozone sovereign ratings. A time limit on the ECB's extraordinary response could, moreover, cut short next year's economic recovery and test European cohesion.

Eurozone Sovereign Ratings Could Be Affected If the ECB's Independence Is Constrained

The ECB's governing board has emphasized its willingness to increase the size of its asset purchase programs and widen its criteria for acquiring public and private bonds to support the eurozone economy throughout 2020. We expect that the ECB's total net asset purchases during 2020 will comfortably exceed 9% of eurozone GDP, including €750 billion purchases under the PEPP. In this context, several of our recent rating actions rely on the understanding of "whatever it takes" support by the ECB to the euro area economies.

Since April 13, 2020, S&P Global Ratings has affirmed ratings on Austria, Belgium, Spain, France, Germany, Italy, and Portugal. A key assumption in these affirmations was that most of the sovereign debt newly created this year on the national balance sheet level as a consequence of the pandemic will be purchased by the national central bank members of the Eurosystem under pre-existing and new initiatives. Should this, and broader funding availability, come under question, it could change our base-case assumptions and add pressure to the ratings.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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• Sovereign Risk Indicators, April 24, 2020
• EU Response To COVID-19 Can Chart A Path To Sustainable Growth, April 22, 2020
• Sovereign Ratings And The Effects Of The COVID-19 Pandemic, April 16, 2020
• The European Central Bank Rises To The Challenge As Eurozone Sovereign Borrowing Soars In Response To COVID-19, March 19, 2020
• Eurozone Sovereign Creditworthiness Unaffected For Now From Coronavirus-Related Effects On Growth, March 10, 2020