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ECB to play it safe

Jun 25 2012 07:40 Reuters

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Frankfurt - Investors are clamouring for a "shock and awe" crisis response from the European Central Bank (ECB) akin to the massive money printing in the United States and Britain, but the bank seems far from following suit despite the eurozone's spreading turmoil.

Pressure is building for something to give. The policies eurozone governments are working on - a drive towards fiscal integration with an overarching banking union - will take months or years to put in place, and financial markets appear in no mood to give them that long.

One hedge fund manager active in Europe said markets wanted the ECB intervene to halt the rise of sovereign bond yields, or governments to mutualise their debts - meaning the strongest states would effectively guarantee the bonds of the weakest.

Without such actions, yields on bonds issued by "peripheral" eurozone states would be pushed even higher, foremost in Spain.

A rise in Madrid’s medium-term borrowing costs to euro-era record levels at an auction on Thursday highlighted the pressure facing the eurozone's fourth-largest economy, and Italy has also come into the firing line.

Still, analysts do not expect the ECB - which is forbidden from financing governments' debts and deficits - to buckle in its resistance to taking major unorthodox action.

So far, the ECB is merely tinkering with existing policies.

Central bank sources say it is discussing ways to help Spain and its troubled banks - which are already due to receive up to €100bn under a eurozone rescue plan - such as further widening the types of collateral they can use in borrowing from the ECB.

This could head off a deeper funding crunch for the banks, which are struggling with huge bad loans due to recession and a property market crash, but essentially only preserves the status quo.

"The ECB continues to believe that the burden of crisis management should fall on the shoulders of the member states," said Mujtaba Rahman, analyst at political risk consultancy Eurasia Group.

"That position is unlikely to change in response to market dynamics and different signalling from the Fed/Bank of England," he added. "It's unlikely that any non-standard measures get adopted by the bank in the near future."

The Federal Reserve launched another round of monetary stimulus under its Operation Twist last Wednesday, and said it was ready to do even more to help an increasingly fragile US economic recovery.

The Bank of England is also close to releasing a wave of new money into the shrinking British economy to counter knock-on effects of the eurozone debt crisis.

This would effectively involve printing money to buy government bonds, in turn lowering British borrowing costs. Such "quantitative easing" (QE) is a no-go area for the ECB.

"As far as QE and the big nuclear answer is concerned - they are not there, they are not going to be there, they are not going to do that... This is a fiscal debt problem, it's going to take some time to resolve," said Sassan Ghahramani, CEO of US-based SGH Macro Advisors, which advises hedge funds.

Legal constraints

The ECB is prohibited by EU law from "monetary financing" of governments' debts and many of its policymakers - particularly those from Germany - are already uncomfortable with bond purchases which the bank made on the secondary market last year.

Executive board member Benoit Coeure, who has often shown a pragmatic attitude since joining the ECB at the beginning of this year, showed no willingness to follow the Fed's example this week. Instead he put the onus on eurozone governments to use the EFSF bailout fund to buy bonds.

"Don't mix the central bank with the fiscal authorities," he told the Financial Times in an interview.

Any commitment from government leaders at a June 28-29 European Union summit to new measures to tackle the crisis, even if they take time to deliver, could give the ECB cover to take more action.

In addition to the collateral changes, the obvious responses for the ECB are to cut interest rates, restart the bond-purchase programme or offer banks another operation to flood markets with more liquidity.

The ECB released over €1 trillion in cheap three-year loans to banks in December and February, taking the heat out of the crisis in the first quarter of this year.

Diminished returns could be expected from a repeat of the long-term refinancing operations (LTROs), which some policymakers would probably oppose, although many analysts nonetheless expect another this year.

Berenberg Bank economist Christian Schulz said Spanish banks still lacked sufficient liquidity and another LTRO, combined with relaxed collateral rules, could address that problem.

"If you relax collateral requirements so the ECB can refinance a bigger share of the banks' balance sheet, that gives Spanish banks also a lot more leeway potentially," he said.

A short-term fix could store up longer-term problems. If Spanish banks took more ECB money, they may well use it to buy more government debt. Analysts say this "loop of doom"”, in which weak banks being propped up by weak governments buy the debt of those sovereigns as its value falls, has to be broken.

Buying time

ECB president Mario Draghi must be careful not to create another division on the policymaking Governing Council with further "non-standard" measures, such as LTROs or a revival of the bond purchases.

German ECB policymakers Axel Weber and Juergen Stark quit last year in protest at the bond-purchase plan, or Securities Markets Programme (SMP), and a new split would unsettle markets.

Opposition to the programme remains staunch, with even Coeure saying: "We do not consider that the SMP would be the best instrument to use at the current juncture."

Part of the ECB's concern about using the SMP is that it could be counter-productive. The bank did not write down its holdings of Greek government debt when private bondholders were forced to accept heavy losses earlier this year.

This spooked investors, who could flee other peripheral bond markets if the ECB intervenes out of fear they could carry heavy losses again under any Greek-style debt swap while the central bank escapes the pain.

That leaves a cut in interest rates as a possibility for the ECB's next policy meeting on July 5, an option several policymakers have mentioned since they left them unchanged on June 6.

Berenberg's Schulz expects the ECB to cut rates by a one-quarter of a percentage point at the July meeting and offer another LTRO.

But he said this would buy the eurozone time only if government leaders come up with a growth initiative at their summit this month, along with longer-term plans for a banking union and more clarity on fiscal integration.

"The end of the crisis is when the countries have gone through all the reforms and start growing again, which will take time, but this could buy us a period of calm," he said, adding that combined action from the ECB and the summit could buy about three months' respite.

In the absence of "shock and awe" from the ECB, the eurozone may settle into a protracted state of crisis with bond yields that are high but just about bearable, until governments set up longer-term solutions.

Markets' impatience could be tempered somewhat if they see a combination of some ECB action and government leaders making longer-term plans, said Ghahramani at SGH Macro Advisors.

"If Spain were to get off from funding completely, clearly we would have an immediate problem on our hands," he said. "At these levels, it's ugly but we can go on for a little while in an ugly situation." 

ecb  |  europe debt crisis
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