ECB struggling to square euro circle

THE European Central Bank is thinking the unthinkable to save the euro, including resuming its bond-buying programme and possibly even pursuing quantitative easing — in effect printing money.

Bold action is probably at least five weeks away, though some 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. These include a request for assistance from Spain, which Madrid is still resisting, a decision by eurozone 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.

Draghi raised expectations last week that the ECB would resume buying sovereign bonds as Spanish and Italian borrowing costs vaulted towards levels that could force the eurozone’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.

His remarks surprised some colleagues on the ECB’s policy-setting Governing Council, who had not been consulted, bank sources said.

The counterblast from the Bundesbank came within 24 hours. The once mighty German monetary authority, the biggest shareholder in the ECB, declared its opposition to reviving the dormant bond-buying programme, arguing 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 eurozone’s rescue fund a banking license and letting it borrow from the central bank to fight fire in the bond markets, on the grounds 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.

The ECB has already cut interest rates to a record low 0.75%, bought €211.5bn worth of troubled eurozone governments’ bonds.

Short-term options for further action include a deeper cut in rates and a further easing of collateral rules.

The main idea under consideration is re-activating the bond-buying programme for Spain and Italy in tandem with the eurozone’s rescue funds.

Supporting Spain would entail a negotiated agreement stipulating fiscal targets and economic reform conditions and international monitoring of them. 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 eurozone banks after lending them €1tn 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 US 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 eurozone countries, are also on the central bankers’ radar screen, the sources said.

The latter would emulate the US Federal Reserve and the Bank of England policy known in central bank jargon as quantitative easing, and to ordinary citizens as printing money.

A risk of deflation could give the ECB cover to embark on quantitative easing, 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.