November 17, 2011 / 11:58 AM / 8 years ago

Analysis: Despite fuss, ECB ready for some crisis flexibility

FRANKFURT/BRUSSELS (Reuters) - The European Central Bank is ready to show some flexibility in its response to the euro zone debt crisis, despite vocal resistance from a German-led group of ECB policymakers to the bank unleashing the overwhelming firepower it can muster.

The German-led group is resisting international pressure for the ECB to step up its response to the crisis and even act as a lender of last resort to governments, a scenario it fears would compromise the bank’s inflation-fighting focus.

The concerns of this group, which is led by Germans Jens Weidmann and Juergen Stark, reflect a broad feeling within the ECB that governments ensnared in the crisis must not be relieved of the pressure to reform by any ECB intervention.

But ECB officials beyond the German-led group are ready to use the bank’s controversial bond-buying program to help lower government borrowing costs if they reach unsustainable levels, as Italy is experiencing.

Outside observers say the ECB must play a bigger role because government leaders are failing to deliver a credible policy response, leaving the bank as the only institution with the capacity to bring down spiraling borrowing costs.

Governments want to strengthen the euro zone’s EFSF rescue fund to fight the crisis and have set a December deadline to bolster its firepower but these efforts have been undermined by delays, surging borrowing costs and scant investor interest.

“European leaders have let this crisis get out of hand and it is almost at the point where it is beyond their control,” said Garry Schinasi, a former official with the International Monetary Fund, who now advises central banks and governments.

“The European Central Bank has been backed into a corner where it is the only bridge out of the crisis,” he added.

The concept of the ECB being a ‘bridge’ is one that resonates within the bank, where there is a feeling that its bond-purchase program can be used as an intermediate means to ease some of the pressure on crisis-hit governments.

This bridge must lead somewhere, however, and that is why the ECB wants governments to deliver reforms to shape up their economies so they are more fiscally viable and can regain the confidence of financial markets.


Italian bond yields rose to unsustainable levels last week, forcing Italian prime minister Silvio Berlusconi out of office as the ECB retreated from sovereign debt markets.

ECB officials have welcomed the appointment of Mario Monti as Italy’s new prime minister and look forward to his administration delivering austerity measures to restore confidence in Italy’s strained public finances.

In the interim, the ECB is ready to innovate if needed, say experts familiar with the bank’s operations.

Some ECB policymakers beyond the German-led core have already given signs of being ready to be creative.

Marko Kranjec, chief of Slovenia’s central bank and, like Weidmann, a member of the ECB’s 23-member Governing Council, told Reuters on Saturday Italy’s austerity reforms go in the right direction and the ECB was willing to support sovereign borrowers as long as it does not put price stability at risk.

“We are flexible,” Kranjec said. He declined to comment in detail on the ECB’s bond purchases but said they would go “as far as needed.”

The ECB stepped in again to buy Italian government bonds on Thursday, traders said, as the yields on 10-year Italian debt traded above the 7 percent threshold seen as unsustainable for the highly indebted country.

The crisis’ grip on Italy has left in tatters an October deal on more aid for Greece and new powers to enhance the EFSF, in the assessment of one senior EU diplomat, and the eyes of Europe’s leaders are once again turning to Frankfurt.

“Italy has changed the picture,” the diplomat said.

Weidmann has forcefully rejected the idea of the ECB acting as lender of last resort for governments, lending directly to the International Monetary Fund or targeting specific interest rates for individual countries.

Softer options remain, however, such as the ECB increasing its bond purchases, as well as the possibility of the EFSF leveraging up its war chest by tapping the central bank’s refinancing operations.

French Finance Minister Francois Baroin repeated Paris’s view on Wednesday that the EFSF should have a banking license, something Berlin opposes. Such a move would allow the fund to borrow from the ECB, giving it extra firepower.

A more flexible use of the ECB’s bond-purchase program remains a possibility.

The tactics of how to use this tool are determined on a daily basis by the ECB’s six-member Executive Board. Stark is a strong voice on the board but he is quitting the ECB this year in what sources say is a protest at the bond-buy program. He will be replaced by Joerg Asmussen, a self-styled pragmatist.

This personnel change coincides with the growing political pressure from France, and beyond the euro zone, for the ECB to do more to fight the crisis.


Backed into a corner, the least bad option for the ECB may be to expand its bond-buy program and only partially ‘sterilize’ the purchases by taking an equivalent sum in from the market.

By doing so, it would embark on a policy of quantitative easing, as already employed by the U.S. Federal Reserve and the Bank of England.

At present, the ECB sterilizes its bond buys by conducting weekly liquidity absorbing operations equal to the cumulative size of its debt purchases, ensuring it does not directly increase the money supply. If the ECB did not fully sterilize the purchases, it would be embarking on quantitative easing.

Germans, historically scarred by their experience of hyperinflation in the 1920, are loathe to take this road.

An economic slowdown and the threat of deflation could, however, provide the bank the cover it would need to sell a policy of quantitative easing to its German constituency.

ECB President Mario Draghi said earlier this month euro zone inflation was likely to fall below 2 percent next year and the economy likely to grow less strongly than previously thought.

A deterioration in the economy late this year and early next is likely as forward-looking indicators paint a grim picture.

“Then by spring there is a clear case for significantly expanding the ECB balance sheet but doing it under the cover of monetary loosening to save the economy, or save the euro area from deflation,” said Nomura economist Jens Sondergaard.

“If the economy continues to deteriorate, there will have to be some more creative solutions which involve the EFSF in combination with the ECB’s balance sheet,” he added, suggesting the two could work in tandem.

The ECB could continue to justify its bond purchases as a means to smooth the transmission of monetary policy, while additional buying by the EFSF could raise the aggregate downward pressure on borrowing costs, Sondergaard said.

With the market pressure on Italy unrelenting, Schinasi said the ECB needed to drop its objections to quantitative easing.

“From a philosophical point of view, they should not touch it but they have no choice,” he said. “They could have to step outside the boundaries of their statutes and their credibility will be damaged. But the risk of not doing so is being blown out of existence. If the euro breaks up there is no longer an ECB.”

Editing by Mike Peacock

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