Contagion Fears Hang Over European Bank Rate Meeting

Tuesday, 04 May 2010 11:56 AM

 

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Fears that a bailout for Greece won't halt Europe's debt crisis could push the European Central Bank to take an even bigger role in stabilizing the situation — and rescuing the euro from the worst crisis since it was created 11 years ago.

The bank raised eyebrows across Europe Monday by dropping a key collateral requirement for using Greek bonds to obtain short term central bank financing — and economists are now looking to see if more unorthodox steps are coming.

Such questions are likely to dominate the bank's interest rate-setting meeting of the bank's governing council on Thursday. No change in the bank's key interest rate, now at a record low of 1 percent, is expected — in part because of the danger that the Greek bailout will not keep bond markets from turning on fiscally challenged Portugal and Spain.

Bank President Jean-Claude Trichet is expected to confirm rates are on hold for the 12th straight month despite recent encouraging signals that the recovery from the recession in much of the euro zone is gathering steam — figures next week are set to confirm that. Under normal circumstances, that would ordinarily raise concerns about inflation, and higher rates are the bank's chief weapon against rising prices.

But Greece's troubles have shaken the entire euro system by showing that the rules that came with the shared currency are not enough to keep governments from running into debt troubles. Greece's 15 partners in the euro zone and the International Monetary Fund agreed Sunday to give the country 110 billion euros ($144 billion) to avoid an imminent, disastrous default.

The bailout, which is likely to be approved around Europe's capitals over the coming week, will help ease the near-term pressure on Greece as debts come due over the coming year or two.

But it has done little so far to ease market worries that Portugal and Spain may be in the line of fire soon — those fears pushed the euro down to a new one-year low of $1.3055 Tuesday and increased the interest rate demanded to hold Portuguese debt.

Investors are skeptical about the ability and inclination of the euro zone — and especially its largest member, Germany — to bail out anyone else. So the ECB may have to play a more central role in resolving the crisis.

For Trichet, one of the chief guardians of the euro, it's important that such talk fades. That may help explain why the ECB said Monday it was suspending its rating limits on using Greek debt as collateral for short-term credit from the central bank — a key source of crisis funding for the financial system. That move — a big surprise since it in effect treats one country differently than the other 15 — helps prop up the Greek banking system by giving the banks money in exchange for their holdings of hard to sell, devalued Greek bonds, thought to total around 45 billion euros.

Last week, Standard & Poor's cut its rating on Greece to junk status, igniting market fears that if the other two leading agencies Moody's and Fitch did the same, then Greek debt would have rated too low to be eligible for ECB money — leaving Greek banks in trouble.

A number of analysts are beginning to think that the ECB will go even farther to keep Spain and Portugal from being dragged into a debt crisis quagmire like Greece, where market fears led to interest demands so high Athens couldn't borrow any more.

The idea being openly discussed is that the ECB may support bond prices — and the balance sheets of banks holding them — by buying government bonds even though the bank's constitution says it can't directly bail out profligate governments.

"Ultimately, the ECB may have to rewrite the rules," said Neil Mackinnon, global macro strategist at VTB Capital.

One option could be for the ECB to get round the no bailout rule by buying bonds on the secondary market from the banks instead of the governments — a Spanish bank, say, would go to the ECB and exchange Spanish bonds, which could be junk status, in exchange for cash.

"That would prevent a banking crisis, provide liquidity, underpin solvency and indirectly help fiscally challenged governments to fund themselves," said Mackinnon..

Trichet has been careful not to get embroiled in speculation — on Sunday after the Greek bailout was agreed, he insisted that "at this stage, we have absolutely no decision on the purchase of government bonds."

Jacques Cailloux, chief euro zone economist at Royal Bank of Scotland, said that statement was reminiscent of his comments at the post-meeting press conference in March relating to numerous questions on whether the ECB planned to alter its collateral policy.

Cailloux thinks that the ECB would be better "breaking the rule-book than breaking up the euro area" and use this opportunity to take the helm to deliver the best bet to resolving the biggest crisis to afflict the euro since its launch in 1999 — actually purchase government bonds in the bond markets.

"It should regain its leadership in tackling the crisis following a complete communication and coordination failure amongst euro area fiscal authorities around the Greek crisis," he said.

© Copyright 2014 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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