| FRANKFURT/PARIS, July 30
FRANKFURT/PARIS, July 30 The European Central
Bank is thinking the unthinkable to save the euro, including
resuming its controversial bond-buying programme and possibly
even pursuing quantitative easing - in effect printing money.
Bold action is probably at least five weeks away, insiders
say, though some more clues may come when the ECB reveals its
latest interest rate decision on Thursday.
Several other pieces have to fall into place before the ECB
will act decisively, insiders say. These include a request for
assistance from Spain, which Madrid is still resisting, a
decision by euro zone leaders to let their bailout fund buy
bonds at auction, and a German court ruling on the legality of
the euro zone's permanent rescue fund, due on Sept. 12.
Above all, ECB President Mario Draghi must overcome the
resistance of Germany's powerful central bank, the guardian of
monetary orthodoxy, glowering from the other side of Frankfurt.
Draghi raised expectations last Thursday that the ECB would
resume buying sovereign bonds as Spanish and Italian borrowing
costs vaulted towards levels that could force the euro zone's
third and fourth largest economies out of the credit markets.
"Within our mandate, the ECB is ready to do whatever it
takes to preserve the euro. And believe me, it will be enough,"
he told a pre-Olympic investment conference in London.
Draghi made it clear he believes the ECB can legitimately
intervene in bond markets to curb the high interest rates
investors are demanding for buying Spanish and Italian debt
rather than safe-haven German Bunds. "To the extent that the
size of the sovereign premia hamper the functioning of the
monetary policy transmission channels, they come within our
mandate," he said.
His remarks surprised some colleagues on the ECB's
policy-setting Governing Council, who had not been consulted,
central bank sources said.
The counterblast from the Bundesbank came within 24 hours.
The once mighty German monetary authority, now an affiliate
and the biggest shareholder in the ECB, declared its opposition
to reviving the dormant bond-buying programme, arguing that it
would remove market pressure on heavily indebted governments to
pursue austere budget policies and economic reforms.
"The mechanism of bond purchases is problematic because it
sets the wrong incentives," a spokesman for Bundesbank President
Jens Weidmann told Reuters.
The Bundesbank has also consistently opposed other ideas -
such as giving the euro zone's rescue fund a banking licence and
letting it borrow from the central bank to fight fire in the
bond markets - on the grounds that they breach a European Union
treaty prohibiting monetary financing of governments.
Draghi and Weidmann will have a chance to thrash out their
differences when they meet before Thursday's monthly meeting of
the Governing Council. The outcome of this struggle between the
ECB and the German parent on which it was modelled may determine
whether the euro survives.
This account of the tug-of-war among Europe's central
bankers is based on numerous conversations with ECB and national
central bank policymakers, European Union officials and private
bankers privy to ECB policy debates, who spoke on condition of
anonymity because of the acute sensitivity of the subject.
The ECB has already cut interest rates to a record low 0.75
percent, bought 211.5 billion euros-worth of troubled euro zone
governments' bonds and loosened its collateral rules so it now
accepts all kinds of paper from mortgage-backed securities to
car loans as surety for funds.
Short-term options for further action include a deeper cut
in rates and a further easing of collateral rules. But both are
seen as having limited benefits and plenty of drawbacks.
The main idea under consideration is re-activating the
bond-buying programme for Spain and Italy in tandem with the
euro zone's rescue funds. Supporting Spain would entail a
negotiated agreement stipulating fiscal targets and economic
reform conditions and international monitoring of them, several
sources in the Eurosystem of central banks said.
To save Spanish Prime Minister Mariano Rajoy's face, such a
programme might be less exacting than the EU/IMF bailouts
imposed on Greece, Ireland and Portugal.
The ECB might also make a third drop of long-term cheap
loans to euro zone banks after lending them 1 trillion euros in
three-year, low-rate funds earlier this year. But much of that
money has so far ended up parked back in the ECB's vaults rather
than being lent to other banks or to the "real economy".
Some central bankers believe a depreciation of the euro's
exchange rate could ease the problems of peripheral countries
such as Portugal and Italy, which compete with China in sectors
such as textiles, shoes and furniture.
The euro has slipped from around $1.50 to just above $1.20
since the sovereign debt crisis erupted in early 2010, but any
deliberate move by the ECB to weaken the exchange rate would be
likely to anger the U.S. Federal Reserve and the Bank of Japan.
Bold options such as accepting losses on ECB holdings of
Greek government bonds, and the ultimate "Big Bazooka" of buying
up masses of bonds from all euro zone countries, are also on the
central bankers' radar screen, the sources said.
The latter would emulate the U.S. Federal Reserve and the
Bank of England policy known in central bank jargon as
quantitative easing, and to ordinary citizens as printing money.
Since the onset of the global financial crisis in 2008, the
Fed has tripled the size of its balance sheet and the Bank of
England's has more than quadrupled; but the ECB's has expanded
less than threefold, mostly through long-term lending to banks.
When the ECB did buy Greek, Portuguese, Irish, Spanish and
Italian bonds, a programme suspended since March, it insisted
that for each extra euro created, a euro was withdrawn from
circulation by taking in interest-bearing deposits from banks.
This is called sterilisation, intended to prevent inflation.
The most radical option for the ECB would be to create money
to buy debt across the euro zone without sterilising the
purchases. Insiders say that if such an operation bought debt
from all euro zone countries, the ECB could avoid accusations of
financing individual governments.
A risk of deflation could give the ECB cover to embark on
QE, and some policymakers think that in extremis the Bundesbank
could go along with such a policy, so long as it did not involve
buying government bonds.
With inflation falling fast towards the ECB's target of
below but close to 2 percent, growth slowing sharply in northern
Europe and recession deepening in the south, the central bank
has unusual scope to move.
By buying assets other than sovereign debt, such as bank and
corporate bonds, the ECB could still pump money into the system
while circumventing the "monetary financing" taboo. One option
would be for the ECB to allow the euro zone's national central
banks to do the bond-buying and carry the risk.
Yet some central bankers worry about whether QE would
achieve the desired result of durably reducing sovereign bond
spreads and reviving inter-bank lending.
The ECB used to be known for an iron grip on its
communications policy. Board members and national central
bankers were assigned key messages to deliver, and massaging
market expectations was one of the great skills of Draghi's
predecessor, Frenchman Jean-Claude Trichet.
That discipline began to fray in the 2008 financial crisis,
when then Bundesbank chief Axel Weber opposed any interest rate
cut below 1 percent. It weakened further in May 2010 when Weber
openly dissented from the ECB's decision to start buying Greek
bonds, arguing that it could be inflationary in the long term.
Weber and former ECB chief economist Juergen Stark both
resigned in opposition to the bond-buying programme, fuelling
German public suspicion of the ECB, which was seen as having
strayed from its German orthodox monetary roots.
Insiders say Draghi, who encourages debate, intentionally
runs a less rigidly controlled ship than Trichet did.
However, several fellow central bankers were furious when
Austria's Ewald Nowotny last week floated the idea of giving the
euro zone's future permanent rescue fund a banking licence, so
it could tank up on cheap ECB liquidity. A legal opinion
previously sought by the ECB had concluded that such a move
would breach the treaty ban on monetary financing of
governments, insiders said.
Nowotny's friends said he wanted to stir up debate and
hinted Draghi was privately sympathetic to his view. Critics say
he just muddied the waters and enraged the Bundesbank.
Within the Eurosystem, officials are puzzling over what will
work. Merely reactivating the ECB's bond buying programme, even
in tandem with bond-buying by the euro zone's rescue funds, may
be too small a bazooka to deter speculators from betting against
Spain or Italy, two central bankers said.
"Hedge funds aren't stupid. They can count. They know how
much is really available from the rescue funds, how much the
central bank has bought so far, and what the political
constraints are on doing more," one euro zone source said.
Even when ECB bond-buying was in full flow last year, the
ECB's Governing Council limited purchases to roughly 20 billion
euros a week, partly at the Bundesbank's behest, insiders say.
The experience remains seared into central bankers' memory
after a debacle with Italy. Within days of making commitments to
deficit cuts and economic reforms to convince the ECB to step
in, then Italian Prime Minister Silvio Berlusconi went back on
his promises and treated them as a joke.
"They felt cheated and they don't want to have that happen a
second time," a senior financial source in the euro zone system
So barring a dramatic deterioration, ECB action may have to
wait until conditions in the markets get still worse, Greece
gets closer to the brink, and the euro zone, in the words of one
Brussels crisis manager, "explores the edge of the abyss".