December 11, 2014 / 11:01 AM / 5 years ago

UPDATE 2-Tepid interest in its cheap loans edges ECB towards printing money

* Modest take-up bolsters chances of buying state bonds

* Result comes as inflation in France turns negative

* Increases pressure on ECB to take dramatic action (Recasts, adds detail)

By John O’Donnell and Paul Carrel

FRANKFURT, Dec 11 (Reuters) - The European Central Bank’s second offering of almost zero-cost loans to banks drew only tepid interest on Thursday, underlining fragile confidence in the euro zone economy and making ECB money-printing appear all but inevitable.

Banks have taken barely more than half the 400 billion euros ($498.28 billion) of loans on offer this year, dealing a heavy blow to the ECB’s plan to avert a downward spiral in euro zone growth and inflation.

Unlike previous such loans, the money cannot be easily parked at the ECB and banks are supposed to lend it on, making it a litmus test of their confidence in borrowers such as small companies, the euro zone’s economic backbone. Banks say credit demand is also weak.

The low take-up in part highlights a darkening mood among lenders, as even mighty China sees its growth slow and the 18-country currency bloc’s economy grinds almost to a halt.

Benoit Coeure, who sits on the ECB’s Executive Board, said the loans would help “improve banks’ access to longer-term liquidity”.

“Together with our other measures they create conditions that stimulate credit growth,” he said.

But many analysts are sceptical that this will happen because they say banks may in part use the fresh credit to repay previous ECB loans.

They see it instead as another reason for the ECB to print fresh money to buy government bonds, shoring up confidence as it pumps billions of euros into circulation.

“The ECB is under so much pressure to move its balance sheet,” said Reinhard Cluse, an economist with UBS. “It needs to have deeper and more liquid pools of assets. That’s a strong case for sovereign bonds.”

JP Morgan said after Thursday’s lukewarm take-up that it expected the ECB to announce plans in January to buy 500 billion euros of sovereign debt.

Banks borrowed almost 130 billion euros ($160 billion) of four-year loans from the ECB in the latest round, bringing total take-up to just over 212 billion euros — far short of the 400 billion euro limit identified by ECB President Mario Draghi.

Underlining the gravity of the situation in the euro zone, France’s core price inflation turned negative, its first drop since records started in 1990.

ECB policymakers have dropped hints recently that the central bank’s Governing Council, with its core executive and governors from across the bloc, could move in the direction of money printing as soon as January.

There are deep divisions on this question, however, with a small group of countries led by powerful Germany opposed, fearing that it would encourage reckless borrowing by spendthrift states which already have huge debts.

“Buying sovereign bonds at this stage could prove to be toxic,” said Lena Komileva of consultancy G+ Economics, reflecting on the split.

But were price inflation to start falling across the euro zone, as they have in Spain, the ECB would be left with no choice but to print more money immediately. Deflation is seen as dangerous for an economy, as consumers postpone buying in the hope that prices will fall further, ultimately forcing companies out of business.

The low demand from banks means the ECB is likely to have to buy government bonds with new money in order to meet a pledge to expand its balance sheet by 1 trillion euros. Expectations it will do so by purchasing assets or lending to banks are helping underpin financial markets.

To compound matters on this front, banks are repaying earlier emergency loans given by the ECB at the height of the crisis, which means that the net impact of the fresh round of credit may be small.

Unlike previous similar offers, where banks simply parked much of the money with the ECB as a safety buffer, this time around, they would have to pay a penalty for so doing.

But finding opportunities to use the ECB money for lending is difficult, as the euro zone economy slows and business confidence wanes.

“The euro zone is overshadowed by global worries,” UBS’s Cluse said. “The ability of banks to use these funds for new loans is limited.”

$1 = 0.8028 euros Editing by Catherine Evans

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