Pressure mounts on ECB to bring down bond yields

ROME/FRANKFURT Tue Sep 4, 2012 2:22pm EDT

1 of 2. European Central Bank (ECB) President Mario Draghi speaks during the monthly news conference in Frankfurt August 2, 2012.

Credit: Reuters/Alex Domanski

ROME/FRANKFURT (Reuters) - France and Italy piled more pressure on the European Central Bank on Tuesday to agree steps this week to reduce crippling borrowing costs for southern euro zone states.

But the bank is expected to outline rather than detail its strategy on Thursday in order to keep the pressure on politicians to bring their deficits and debts under control.

Italian Prime Minister Mario Monti and French President Francois Hollande said after talks in Rome that European institutions must act to bring down the bond yields of countries that are unjustifiably penalized by markets.

Monti said he expected measures to remove "the serious obstacle of (bond) spreads that have no underlying economic justification" for Italy and other countries "doing our homework" on economic reform and deficit reduction.

The Bank of Italy said in a study that economic fundamentals justified a risk premium of 200 basis points - or two percentage points - over benchmark German bonds, rather than the 450 basis points that markets were charging at end-August.

Hollande said high debt yields facing countries such as Spain and Italy were not justified and it was the role of EU institutions, including the ECB, to bring them down.

ECB President Mario Draghi will try to back up his pledge to do "whatever it takes" to save the euro when he presents some details on Thursday of a new bond-buying plan that is transfixing markets hopeful it can ease the euro zone crisis.

Investors are on tenterhooks after brinkmanship in the ECB's internal negotiations over the plan was played out in public last week, with one newspaper reporting that Bundesbank chief Jens Weidmann even considered quitting.

The ECB is being forced to take a greater role in fighting the debt crisis while governments negotiate legal and political hurdles to coordinating a longer-term response, but Germany's Bundesbank wants to limit the scope of ECB action.

"Draghi certainly has to present something," said Guillaume Menuet, economist at Citi. "A document of some sort, something of substance is what markets want to see in order to justify valuations."

Spanish and Italian government bond yields fell on Tuesday as investors welcomed leaked comments Draghi made behind closed doors in the European Parliament on Monday, suggesting the ECB could buy bonds with a maturity of up to three years - at the long end of market expectations.

ECB executive board member Joerg Asmussen, the most senior German at the bank, spelled out one key argument for central bank action, saying it was unacceptable that financial markets were now pricing in the risk of a euro break-up.

"The risk premia of sovereign bonds now reflect not just the insolvency risk of some countries but even an exchange rate risk, which there should not theoretically be in a currency union," Asmussen told a banking conference in Frankfurt.

"The markets are pricing in a break-up of the euro zone. For a currency union, such systemic doubts are not acceptable."

However he also said it was crucial to ensure that ECB decisions did not reduce pressure on governments to reform. That is one reason why the central bank is unlikely to reveal all details of the plan on Thursday.

IMPORTANT DATES

"I'm not sure the ECB is ready to publish the nitty-gritty and the procedures of interventions, because no country has asked (for bailout) and because there are still some important dates in the month that require prior approval," said Menuet.

Germany's Constitutional Court will rule on September 12 whether the euro zone's permanent bailout fund is compatible with German law, a vital condition for it to come into force. EU finance ministers meet in Cyprus on September 14-15 to discuss possible additional aid for Spain and Greece as well as plans for joint banking supervision.

Hollande said an October 18-19 EU summit could take decisions on support for both Spain and Greece.

Spanish Prime Minister Mariano Rajoy said on Sunday Madrid would consider seeking extra aid on top of an up to 100 billion euro rescue of its financial sector but sees no need for new conditions beyond the EU guidelines it is already implementing.

Rajoy added he wanted to see details of the ECB's program before deciding whether to proceed with a request. EU paymaster Germany and Draghi have said any bond-buying support would require strict policy conditions and enforcement.

German Chancellor Angela Merkel and Rajoy will try to thrash out those differences at talks in Madrid on Thursday, just as the ECB is due to unveil more on its plans.

Spain and Italy have been sucked deeper into the crisis as investors increasingly doubt their capacity to repay their debt. Yields on their bonds have risen to near-unsustainable levels.

Draghi signaled last month he was ready to resume buying government bonds provided that the euro zone's rescue fund was also involved, and assisted countries accepted strict policy conditions with international supervision of compliance.

Now markets want to hear details of the policy. But internal ECB tensions, fuelled by Bundesbank resistance to bond-buying, and the ECB's eagerness to retain an element of surprise mean it will reveal only a partial outline on Thursday.

"We're expecting limited information, no quantitative indication on the targets or quantities to be purchased," Nomura economist Nick Matthews said. "In terms of modalities, we'll probably get something, but very little color in total."

BUNDESBANK OPPOSITION

The Bundesbank vehemently opposes government bond purchases, saying they come close to breaching the taboo of central bank financing of governments, and its criticism has not let up. Its previous head, Axel Weber, resigned in opposition to a previous bout of bond-buying by the ECB.

Disagreements within the policy-setting Governing Council may keep the ECB from giving too many specifics.

The ECB also wants to keep markets guessing about its bond-buying moves to discourage speculators and maintain pressure on governments to pursue economic reforms and fiscal discipline.

Even in the absence of inflationary pressures, the ECB must show its primary focus is still on guarding price stability.

"The ECB cannot announce an additional target of any sort (in addition to the inflation target) because two targets could come into conflict with one another at some future date," UniCredit economist Erik Nielsen said in a note to investors.

Sources have told Reuters the ECB has considered setting interest rate bands - rather than a specific cap - as internal guideline for intervention, but it would not publicly declare any target for yields or spreads that would force it to enter the market when the barrier was exceeded.

Weidmann's reported threat to resign, though not confirmed, has piled pressure on Draghi to mollify opponents of the plan without tying it up in so many knots it is rendered ineffective.

One way could be to insist that the International Monetary Fund - seen as tougher than EU institutions - is involved in setting conditions for bailouts, and hence for bond buying, as suggested by the ECB's Asmussen.

"The ECB cannot write a blank cheque," said Menuet at Citi.

While the bond-buying plan will be the main focus of Thursday's meeting, there is a chance the ECB will also cut interest rates from 0.75 percent - already a record low - due to a deepening slowdown in the euro zone economy.

Analysts in a Reuters poll are split on the chance of a cut, with a slight majority thinking it will hold fire.

Whether a rate cut comes may depend on how many details of the bond program the ECB can present.

"Draghi will probably disappoint at least marginally on the intervention part, so to compensate for the lack of details on the bond-buying part, they could also be inclined to cut rates," said Nordea analyst Anders Svendsen.

(Additional reporting by Eva Kuehnen and Paul Carrel in Frankfurt, Francesca Landini in Milan, Gavin Jones in Rome; Editing by Paul Taylor and Janet McBride)