Fresh fears of a eurozone meltdown swept through markets on Tuesday after German judges gave the European Central Bank a three-month ultimatum to fix flaws in its bond-buying programme.
The euro dropped, stocks slipped slightly and Italian bonds led a government debt sell-off after Germany’s constitutional court issued the ruling in a 7–1 judgement economists called a “legal bombshell”.
Declaring themselves unbound by a 2018 European Court of Justice ruling that upheld the scheme’s validity, the judges said the ECB’s controversial public sector purchase programme had failed to comply with European Union treaties.
Germany’s Bundesbank will be prohibited from participation in the programme after the three month period elapses unless the ECB can demonstrate that it was justified, they ruled. The German central bank is the biggest debt-buyer under the scheme.
The ECB’s Governing Council held an emergency conference call on Tuesday evening to discuss its response to the decision. In a statement, the central bank appeared to rebuff the German judgement.
“The Governing Council remains fully committed to doing everything necessary within its mandate to ensure that inflation rises to levels consistent with its medium-term aim and that the monetary policy action taken in pursuit of the objective of maintaining price stability is transmitted to all parts of the economy and to all jurisdictions of the euro area,” it said.
Jens Weidmann, president of the Bundesbank, said the court’s ruling highlighted the bond-buying scheme contained safety features that prevented it providing direct funding to governments, adding he would support the ECB in developing its response.
The ruling allayed fears that the German court would deem the scheme illegal – an outcome that analysts said could have plunged the eurozone into an immediate crisis.
Nonetheless, it has set off a time bomb beneath the eurozone economy, which ECB officials will have to defuse while also managing a gigantic relief programme to tackle the impact of Covid-19.
Henrik Enderlein of the Hertie School of Governance in Berlin tweeted: “From a European integration perspective, the ruling is a disaster... How would Germany react if Hungarian or Polish courts issued such statements?” The decision marked the return of potentially “lethal” economic nationalism within the EU, he added.
Berenberg economists Holger Schmieding and Florian Hense said the decision “could have been worse”, but warned it would have severe consequences.
“That the German court rejects a key plank of a decision by the European court is a legal bombshell which will make significant legal waves across Europe,” they wrote.
The dispute was triggered after the introduction of the scheme in 2015 under former ECB chief Mario Draghi. A group of German eurosceptics filed a lawsuit, claiming the ECB had overstepped its remit by intervening in economic policy.
The German court asked the European Court of Justice to rule on the case in 2017. It backed the ECB’s quantitative easing efforts with some added conditions.
In its judgement on Tuesday, the German court slammed that ruling, saying it “contradicts the methodological approach taken by the [ECJ] in virtually all other areas of EU law” and declared it was “not bound” by the ECJ’s decision.
Carsten Brzeski, chief eurozone economist at ING, said the German judges had come back against the ECJ “with vengeance” in their ruling.
“It did not only basically tell the European Court of Justice that it didn’t have a clue when coming up with its verdict, but it also puts new uncertainty with open questions in the eurozone and the ECB,” he said.
Economists at Bank of America called the ruling “tricky”, adding: “It doesn't force ECB to change course immediately, but undermines its credibility.”
The bond-buying scheme ran until the end of 2018, before being relaunched last November at the end of Mr Draghi’s tenure – a decision that sparked a rift in the ECB’s governing council.
Total holdings under the scheme were about €2.7 trillion (£2.2 trillion) at the end of March, with a further €300bn of purchases expected by the end of this year.
“The German constitutional court ruling today will not bring the ECB’s asset purchase programme to a sudden end,” said Andrew Kenningham of Capital Economics. “But it highlights that a successful legal challenge to its policies in the future could contribute to increased tensions in the bond markets and to a renewed risk of euro-zone break-up.”
The ruling also threatens the ECB’s new pandemic emergency purchase programme, a €750bn scheme designed to help lenders to continue supporting businesses and families amid the economic shock caused by the coronavirus outbreak.
ECB president Christine Lagarde has said the bank will expand, alter or extend the pandemic scheme if needed.
Tuesday’s judgement does not directly affect the new scheme, but the German court’s actions raised the possibility of further legal battles over the Covid-19 relief programme.
Strategists at Swedish bank SEB said it was likely the ECB would be able to justify its actions to the court, but warned “more court wrestling may be expected in coming years”.
The euro was hardest-hit by the outcome, dropping 0.6pc against the dollar in just a few minutes as traders digested the court’s judgement. European stock markets handed back some of their early-session gains following the ruling, but had largely recovered by early afternoon.