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Why the ECB could be forced to exercise 'nuclear' policies in the event of a political crisis

The euro sign sculpture illuminated near the former European Central Bank headquarters in Frankfurt, Germany.
Krisztian Bocsi | Bloomberg | Getty Images

The European Central Bank (ECB) is faced with an unprecedented political challenge this year as key member states prepare to elect new leaders, though not everyone is convinced the central bank has the tools necessary to weather a populist storm.

"I am a bit worried… if something goes wrong this year then I'm afraid the ECB would not be in a position to stop the crisis as it has done before, it would be much more complicated," Frederik Ducrozet, senior economist at Pictet Wealth Management told CNBC in a phone interview.

Investors appear to be increasingly nervous ahead of scheduled elections in the Netherlands, France and Germany after failing to foresee the outcomes in the U.K.'s Brexit vote as well as U.S. President Donald Trump's victory last year.

The significant rise in support for populist parties throughout the bloc could conceivably lead to governments putting additional strain on the ECB's ability to smooth over any market turmoil.

ECB's 'nuclear weapon'

European Central Bank chief Mario Draghi attends the Committee on Economic and Monetary Affairs at the EU headquarters in Brussels on June 21, 2016.
John Thys | AFP | Getty Images

When faced with the euro crisis in 2012, President Mario Draghi adopted a defiant tone to sooth concerns with a promise to do "whatever it takes" and as a result bond yields narrowed considerably and market tensions evaporated. However, the unpredictable nature of upcoming general elections in some of Europe's leading economies present the ECB chief with a unique challenge.

"This time is really different on so many levels. It has never been the case since the ECB started that its most important elections take place at the same time. Outright Monetary Transactions (OMT) is the first reactionary step to take in a crisis and it has already been mentioned as part of (the ECB's) toolkit though in practice it doesn't work… For some countries, it is just un-syncable (and) it is not a nuclear weapon that can solve such a crisis." Ducrozet added.

Draghi introduced the OMT program in September 2012 shortly after he had vowed the central bank would exercise whatever means necessary in order to save the euro zone from collapse. The program involves the ECB purchasing short-term sovereign debt from beleaguered euro zone economies in a theoretically limitless capacity to prevent market panic and fix a financial crisis. It remains the ECB's most controversial and "nuclear" policy.

In the meantime, Europe's central bank continues to support euro zone economies with its massive trillion-euro bond-buying program, albeit at a reduced rate of purchases from April. It could be argued the central bank's remarkably accommodative quantitative easing (QE) program already provides more than enough support for the bloc.

"The irony of the ECB's current QE program is that it hinders the (central bank) to easily tackle a political crisis and market turmoil. QE has paralyzed bond markets… In short, the ECB would have to replace QE with tailor-made OMT," Carsten Brzeski, chief economist at ING Germany told CNBC via email.

Fire-fighting to prevent chaos

Marine Le Pen, French National Front (FN) political party leader and candidate for French 2017 presidential election, at a political rally in Saint-Herblain near Nantes, France, February 26, 2017.
Stephane Mahe | Reuters

Draghi has become somewhat of a political lightening-rod in Frankfurt, where many analysts, bankers and citizens blame the Italian central banker for penalizing German savers as he seeks to boost the euro zone's ailing economies. Brzeski's prediction of tailor-made OMT in the event of a potential political crisis this summer would almost certainly inflame simmering frustrations from Europe's economic powerhouse.

"I think that Germany would not oppose ECB fire-fighting. In the end, a chaotic break-up of the euro zone would also harm the German economy. Let's not forget that even if Germany was to leave the euro zone, this would mean a sharp appreciation of the currency combined with even lower interest rates. Not the best prospects for the German economy," Brzeski added.

Though German voters are poised to elect a new government in September, arguably it is the French general election in May that has the most potential to cause a volatile market response. Far-right and anti-establishment candidate Marine Le Pen has said she wishes to renegotiate France's European Union membership and even take the country out of the euro if elected president. Analysts from Citi estimate Le Pen has a 20 percent chance of victory in two months' time.

"We see 'downside risks' for the euro area economy from political insecurity. Whether these risks materialize we don't know and in general – as you've seen after the Brexit vote – it's not easy to calculate market reactions beforehand," an ECB spokesperson said in an email to CNBC.

"Whatever economists might tell you: (a) precondition for OMT is always a European Stability Mechanism (ESM) program, so a lot of political decisions have to be taken before the ECB comes into play with its own independent assessment," the ECB spokesperson added.

ECB could opt against defensive action

ESM, which represents the euro zone's permanent bailout fund for troubled economies, was first triggered in 2012 to provide financial assistance for Spain to help strengthen the country's banks. As one of the key defensive policies the ECB has at its disposal, the Luxembourg-based agency could be called upon to deliver support to euro zone economies heavily impacted by political turmoil.

"The ECB has several lines of defense if there is a surprise result in the elections this year but if Le Pen is to announce, as she promised, she is going to hold a referendum to quit the EU then I don't see the ECB granting any lines of defense to try and help," Maria Demertzis, deputy director at Brussels-based think tank Bruegel, told CNBC in a phone interview.

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