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EU's central bank may intervene on bonds

Friday, August 03, 2012    

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FRANKFURT, Germany - European Central Bank President Mario Draghi said Thursday the bank would make a new effort to buy government bonds to drive down the high borrowing rates squeezing the continent's indebted governments. And he urged leaders of the 17 countries that use the euro to use their bailout fund to do the same.

The message from the ECB was clear: Europe's financial crisis is getting worse and requires more forceful remedies than leaders have so far been able to come up with.

Financial markets were disappointed that there was no immediate action and that the ECB had few specifics to offer on its emerging plan. Stocks were sharply lower across Europe, while borrowing costs for heavily indebted countries such as Spain and Italy crept higher.

Draghi said ECB policymakers will work on a more detailed plan in coming weeks, including how much money to put into the effort, which would aim to lower the interest rates on governments' short-term bonds. The ECB chief's remarks followed a decision by the ECB to keep its benchmark short-term interest rate unchanged at a record low 0.75 per cent.

"There wasn't any specific instance that led us to the decision we had today, just a sense of the worsening crisis and the worsening consequences," Draghi said. He said a recent spike in interest rates for the short-term bonds of countries such as Spain and Italy was a "symptom" of the stresses being felt across the region.

The negative reaction in markets was strongest in Spain and Italy, the third- and fourth-largest economies in the eurozone and the countries most vulnerable to high borrowing costs. The interest rate, or yield, on Spain's 10-year bonds rose above seven per cent, while the country's main stock index plunged by nearly five per cent. The yield on Italy's 10-year bonds climbed above six per cent and the country's main stock market index sank by more than four per cent. The euro fell 0.2 per cent to US$1.2215 ($108).

In the US, the Dow Jones industrial average fell 144 points to 12,827.

Financial markets in the US and Europe had risen last week after Draghi gave a speech in London that many investors interpreted as a signal that ECB action was imminent.

"The ECB disappointed those who had hoped for the Big Bertha to fire immediately," said Joerg Kraemer, chief economist at Commerzbank. "Instead, the ECB wants the problem countries to first turn to the...bailout fund."

The signal from the ECB that more help is on the way came a day after the Federal Reserve hinted it was leaning toward taking further action to stimulate growth in the US if hiring remain weak. The Fed said in a statement it would closely monitor economic data to determine whether and when to take additional steps. Many economists believe the Fed could announce a new bond-buying program at a September meeting. The goal would be to further reduce long-term interest rates, which are already at historical lows.

This would not be the first time the ECB has purchased government bonds from banks on secondary markets to help drive down interest rates. That effort began in May 2010 and stopped in March after it did not decisively lower borrowing costs. The ECB purchased more than (euro) 210 billion($22.6 trillion) in government bonds, an intentionally modest effort that had limited capacity.

By contrast, the US Federal Reserve spent US$2.35 trillion in two rounds of bond purchases aimed at expanding the money supply and driving down interest rates. The US has an easier time with borrowing rates because of strong demand for its debt from other countries whose central banks use Treasuries as dollar reserves. That's the exact opposite for Spain and Italy, where investors are fleeing because of default fears.

Draghi's comments Thursday appeared to signal a growing resolve at the ECB to be more aggressive in fighting Europe's financial crisis.

"It's pointless to bet against the euro," Draghi said, following up comments he made last week that the ECB would do "whatever it takes" to preserve the currency union.

The ECB has been cautious because its charter states that the bank cannot finance governments' debts. On top of this further steps remain before any actual bonds are bought. ECB committees will study what the bank will do and another decision of the governing council would be needed.

Draghi was careful to add that the bank would be acting independently to determine monetary policy and interest rates -- a signal that the ECB would not be influenced by political leaders who have been pressing the ECB to take a more active role. He acknowledged skepticism on the part of Germany's Bundesbank head Jens Weidmann, who sits on the ECB board, and said the any action on bond buying would need a further decision of the board before it could be launched.

Still, Draghi emphasized that ECB action alone cannot save the euro. He pressed leaders of the euro region to "push ahead with fiscal consolidation, structural reform and European institution-building with great determination."

He said the eurozone governments "must stand ready" to use their bailout funds, the European Financial Stability Fund and its successor, the European Stability Mechanism, in direct market interventions themselves. Countries would have to ask for that help first, which would take time, while the ECB can act at any time.

The bailout funds could play a key role because they can enforce tough conditions in return for help, such as further economic reforms. Draghi said that such interventions could give governments time to fix their budgets and reform their economies in order to convince lenders they can pay debts and get out of the crisis. He warned that the bank's efforts couldn't replace that.

Draghi also addressed a technical issue that has been worrying markets, saying private investors concerns about being behind governments in the line to get paid "will be addressed."

So far the ECB has insisted on being fully repaid on any bonds it buys in case of default, leading other creditors to fear there would be no money left for them.

Member governments of the 17-country euro have had to bail out Greece, Ireland and Portugal after high borrowing costs left them unable to pay their maturing debts. Countries must regularly sell new bonds to pay off old ones that are coming due. Spain and Italy are much larger and if they should be cut off from affordable borrowing, any bailout would strain the eurozone bailout funds resources. Letting them default could meant heavy losses for banks and markets worldwide and could choke off credit to the wider economy.

The temporary EFSF has (euro) 440 billion in lending power, most of it committed to the bailouts for Greece, Ireland and Portugal. The ESM has not come into effect yet and will have (euro) 500 billion, (euro) 100 billion already committed to a bank bailout for Spain. Yet Spain and Italy together have some (euro) 2.5 trillion in debt. Italy's (euro) 1.9 trillion is the world's third largest bond market, after the US and Japan.

Draghi noted that some of the excess interest demanded by investors comes from fear that the euro will break up and their investments will be denominated in a currency that is worth less. He issued a fierce warning to financial markets, saying premiums based on expectations of euro break up were unacceptable because the euro is "irreversible."

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