May 26, 2010 / 5:06 PM / 9 years ago

ECB FOCUS-Plenty of ammunition left in ECB's arsenal

* Cut in refi rate, end to sterilisation unlikely

* But ECB could offer long-term euro, dollar funds

* Currency intervention probably not on cards for now

* Some suggest ECB might issue CDS

By Sakari Suoninen

FRANKFURT, May 26 (Reuters) - The European Central Bank has plenty of ammunition left in its arsenal to fight trouble in the economy and banking system, although it has already fired its biggest gun at the government bond market.

Earlier this month, the ECB resorted to what traders described as its “nuclear option”: buying sovereign bonds to help Greece and other weak European countries get through their debt crises.

The ECB also threw its gradual phasing out of emergency lending into reverse, resuming its offers of unlimited funds in three-month maturities, and it suspended minimum credit rating requirements for Greek government bonds used in its money market operations.

Overcoming its reluctance to follow other central banks into buying bonds was a big step for the ECB, and some in the markets worry that the central bank may have exhausted its supply of new weapons to take on the crisis.

“What’s left? Not a lot, they’ve already crossed the last line,” said ING economist Carsten Brzeski.

But the ECB still has plenty of ways in which it could expand its assistance to the money markets, and the reason it has not used them so far is probably that it thinks the crisis remains manageable with its current methods — not that it has run out of effective options.

Governing Council member Athanasios Orphanides made this case when questioned about the ECB’s ability to act, saying it had unlimited scope for non-traditional measures.

“The room for conventional easing may be limited but the ammunition for unconventional policy easing is unlimited,” he said last week. [ID:nLDE64K1G5]


The failure of a small Spanish bank last weekend stirred concern that the euro zone’s sovereign debt problems might trigger a broader financial crisis similar to the one in 2007-2008, when bank lending almost ground to a halt.

The two-year U.S. bond-swap spread USD2YTS=RR, a gauge of financial system stress, has risen to one-year highs and the equivalent euro swap spread EURAB6E2Y=EU2YT=RR is at its highest level in 16 months.

On the other hand, although spreads between the three-month euro London Interbank Offered Rate and overnight indexed swap prices — another key sign of financial system stress — have also widened, at 25 basis points it remains far below the levels around 200 bps seen in October 2008.

The ECB may be waiting for any major worsening of indicators such as that one, or a more general freezing up of money markets in the euro zone beyond the current borrowing difficulties experienced by commercial banks in a few countries, before deciding on further action.

One potential move is a cut in its refinancing rate, used to lend to commercial banks, which is now at a record low 1.0 percent.

Because the rate is so already so low, and o-zone interest rates are already very low, given markets take their signal from the 0.25 percent overnight deposit rate rather than the 1 percent refinancing headline rate, meaning conventional rate cuts would have little traction.

Still, there is more the ECB could do to help unblock credit jams using tried-and-tested ‘unconventional’ methods. It could expand the array of liquidity on offer by lending over longer maturities in both dollars and euros, make dollar funds cheaper or ease collateral rules further.

Currency market intervention is another option as the euro hovers near four-year lows EUR=, although analysts see this as unlikely. [ID:nLDE64K12A]

Analysts said an easy option would be for the ECB to reintroduce regular six and 12-month refinancing operations in unlimited amounts, which were first used at the height of the financial market turmoil.

“If the aim was to give lifelines to banks, then it could also return to unlimited tenders in not only 3-month, but also 6-month and 12-month LTROs,” Brzeski said.

Extra long-term dollar operations might also help, despite low take-up at an 84-day dollar offer earlier this month — partly blamed on comparatively high interest rates. Banks paid 1.23 percent for seven-day dollar cash from the ECB on Wednesday, compared to a market rate of 0.33 percent. USDLIBOR

“It could decide to diminish the cost of the USD liquidity,” Barclays economist Laurent Fransolet said.

“But we would note that it did not do so even at the worst of the crisis when the demand for USD funding was much higher and conditions were much worse than currently.”

Another option would be to stop mopping up the extra liquidity created by the government bond buys, although analysts said that since the ECB is lending unlimited funds, the sterilisation via one-week deposits is only cosmetic anyway.

ING’s Brzeski said the ECB could also issue credit default swaps for sovereign debt to add liquidity to the thin CDS market and hurt speculators bidding against governments.

“If the aim was to calm down the bond markets, it could simply issue CDS on Greek debt,” he said. “Because the market is so small and so thin, you could simply flood the market with ECB CDS’s to take away the speculative element from the current CDS market.”


Another unused option is currency intervention to prop up the euro. It has lost about 15 percent of its value against the U.S. dollar and about 12 percent on the trade-weighted index EUREER=ECBF this year, faster than the last and only time the ECB has intervened in foreign exchange markets.

In late 2000, the ECB moved to support the euro after it fell 11 percent in 10 months, but the euro was then at a record-low level and is now still close to long-term average. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

For a graph on the euro exchange rate, click: here

For a factbox on ECB currency intervention, click: [ID:nL20669011] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

The ECB can intervene in the foreign exchange markets when it sees price stability in danger — the low euro makes imported goods more expensive — but the ECB and analysts alike see price developments as subdued.

Past ECB statements also speak against an intervention. Executive Board member Lorenzo Bini Smaghi said in 2007 intervention should be go hand in hand with rate moves.

“Intervention is unlikely to have a lasting effect in the foreign exchange markets unless it is expected to be followed by domestic policy action, especially concerning interest rates,” he said. Analysts do not expect the ECB to raise its interest rates this year, much less in the short term. [ECB/INT]

And while an intervention could calm the markets, the drop in the value of the euro boosts the ailing economy.

Moreover, when policymakers have spoken of foreign exchange rates, they have stressed they are not out of the ordinary.

Analysts said the euro would have to fall further before even a joint verbal intervention would take place.

“It would take a further rapid fall of the EUR below $1.10 and towards parity against the USD to arise global concern,” Unicredit’s Marco Annunziata said in a note to investors. (Additional reporting by Marc Jones; Editing by Andrew Torchia)

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