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'Euro backed by whatever it takes'

Friday, July 27, 2012    

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FRANKFURT, Germany — European Central Bank head Mario Draghi promised to do whatever it takes to save the European single currency yesterday, and raised expectations that he could step in to lower the high borrowing costs that are crippling countries like Spain and Italy.

Draghi told an audience of business leaders in London that the ECB would "do whatever it takes to preserve the euro" and added, "believe me, it will be enough."

The remarks were made during a question-and-answer session at an international investment conference organized by the UK government to mark the start of the London 2012 Olympics.

Fears about the 17 countries that use the euro have intensified over the past few weeks. Spain and Italy, in particular, are finding it increasingly expensive to raise money on the debt markets due to spiraling borrowing costs. Investors are losing confidence that the countries will be able to control their debt while they are in recession.

Spain's bond interest rates, or yields, have hit record highs recently as it struggles to prop up its stricken banking sector and meet requests for financial aid from its regional governments. That has raised fears the country may be the next to seek a bailout from the other eurozone countries, following Ireland, Greece, Portugal and Cyprus.

Spain's economy — the eurozone's fourth largest — is much bigger than the other four countries combined and would strain the region's bailout funds.

Also during the question-and-answer session, Draghi discussed the high borrowing costs, or risk premiums, being imposed on some countries' bonds. Using precise, technical terms, the ECB chief said the bank could react against high bond yields if they interfered with its benchmark interest rate policy — the main tool in steering the eurozone economy and keeping inflation down

"To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate," he said.

Stocks across Europe rose on Draghi's comments. Britain's FTSE traded up 1.4 per cent, Germany's DAX index rose 2.75 per cent and France's CAC 40 rose four per cent. Spain's main IBEX stock index rose six per cent while the interest rate on its 10-year bond — a main indicator of market confidence in a country — dropped 0.5 per cent to 6.89 per cent. Italy saw a 5.4 per cent rise in its stock prices and a 0.3 per cent fall in its bond price to 6.07 per cent.

However, Draghi did not say what the ECB might do to intervene on high bond yields — but left markets with the impression that some kind of action was possible. He warned that bank would stay within the legal restrictions imposed by the EU treaty that forbid it from directly helping governments.

The ECB has used similar reasoning before to make limited purchases of government bonds to drive down a government's borrowing costs. Starting in May, 2010 the bank carried out a limited bond purchase program accumulated over (euro) 200 billion in bonds. But it had little effect on bond yields, and the program has not been used for several months — in spite of pleas from Spain for help.

The pressure is on the ECB to act because it is the eurozone's chief crisis-fighter.

The eurozone's current bailout fund, the European Financial Stability Facility, does have some (euro) 440 billion in lending power, but most of that is already committed to bailouts for Greece, Ireland and Portugal. A new, permanent, fund — the European Stability Mechanism — would have some (euro) 500 billion, but has yet to ratified by eurozone member countries and even then is months from coming on line. And (euro) 100 billion of that is already committed to rescuing Spanish banks from collapsing due to bad real estate loans.

In attempts to take pressure off the eurozone's economy, the ECB this year has already cut its main interest rate to a record low of 0.75 per cent It has also loaned (euro) 1 trillion in cheap money to banks in December and February, a move that steadied banks and calmed markets for a few weeks.

Draghi's remarks looked like a "strong hint" that the bank was considering reviving the bond purchases, said Jonathan Loynes of Capital Economics in London. But he doubted the bank would make any large scale purchases, "given the program's previous lack of activity."

"Indeed, the ECB may even be hoping — rather optimistically — that even the mere threat of action will be sufficient."

Any effort that appears to bail out governments, however, remains deeply controversial.

Many officials and economists, particularly in Germany, are wary of anything that resembles violating the European Union treaty's ban on financing governments. They are also concerned that rescue efforts from the central bank will simply take pressure off politicians in indebted countries from cutting spending and reforming labor markets.

The May 2010 effort to buy government bonds continued on-and-off until it was put on hold this March. It was criticized at launch by the then-head of Germany's Bundesbank, and member of the ECB governing board, Axel Weber. This criticism undermined any impression that everyone at ECB was fully behind the action. The bank also stressed that the purchases were limited, further curbing their impact on the bond market.

Another thorny problem is the terms the ECB insists on when it buys bonds. Earlier this year, when Greece was negotiating a bond repurchase program to avoid a chaotic default on its debt, the ECB said it should be paid back in full for its Greek bond holdings. That meant even bigger writedowns for private sector creditors, who had to bear all the losses. Investors will not want a repeat of that when it comes to Spain.

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