IMF says ECB could play bigger role in taming sovereign debt crisis

BRUSSELS Wed Jul 18, 2012 9:00am EDT

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BRUSSELS (Reuters) - The European Central Bank could play a bigger role in fighting the euro zone sovereign debt crisis through more rate cuts, bond purchases and further liquidity provision, the International Monetary Fund said in a regular report on the euro zone.

The IMF also said that the independent ECB, which is legally forbidden to finance governments, could be given full lender-of-last-resort functions, to help break the vicious circle of highly indebted governments borrowing from banks which in turn become vulnerable due to the risk associated with the bonds.

"The ECB can provide further defenses against an escalation of the crisis," the IMF report said.

"These could include policies to support demand in the short run and fend off downside risks to inflation, as well as measures to ensure that monetary transmission, currently impaired by financial stress in some countries," it said.

"And to further strengthen its financial markets role, the ECB could also be given explicit responsibility for financial stability and full lender-of-last-resort functions, thereby eliminating bank-sovereign linkages present in the current Emergency Liquidity Assistance (ELA) scheme," it said.

The IMF said the ECB could further lower borrowing costs, which are currently at a record low of 0.75 percent, because the economy was weak and inflation risks small.

The bank could try quantitative easing (QE) with "sizable" sovereign bond purchases, possibly preannounced over a given period of time, the IMF said.

"Buying a representative portfolio of long-term government bonds -- for example, defined equitably across the euro area by GDP weights -- would also provide a measure of added stability to stressed sovereign markets," the IMF said.

"However, QE would likely also contribute to lower yields in already 'low yield' countries, including Germany," it said.

The ECB could also embark on further sovereign bond purchases of countries that are under market stress -- its Securities Market Programme (SMP).

"A well-communicated re-activation of SMP purchases would likely carry strong signaling effects which might mitigate the need for very large purchases. The benefits from lower yields would also ease collateral constraints on official and interbank lending facilities," the IMF said.

Another way to ease market tensions was to launch another Long-Term Refinancing Operation (LTRO) -- cheap, long-term lending by the ECB to banks that ensures they remain liquid despite the frozen interbank lending market.

"This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed --including a broadened collateral base and/or a lowering of haircuts -- to address localized shortages," the report said.

"The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links."

A priority for the euro zone was to create a banking union, which would entail a common euro zone bank supervisor, as well as a common deposit guarantee scheme and bank resolution fund.

Euro zone leaders agreed the ECB would play the role of the supervisor, but the IMF suggested the bank should also play a role in the bank deposit guarantee scheme, which, while financed from a levy on banks, should have access to an ECB credit line.

(Reporting by Jan Strupczewski; editing by Rex Merrifield)

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