Business

Eurozone cuts key rate to help economy

Friday, July 06, 2012    

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FRANKFURT, Germany - The European Central Bank has cut its key interest rate by a quarter percentage point to a record low of 0.75 per cent to boost a eurozone economy weighed down by the continent's crisis over too much government debt.

The move followed a rate cut by China's central bank (see related story below) and new stimulus measures by the Bank of England as global financial authorities seek to shore up a slowing global economy.

European leaders last week agreed on new steps to strengthen market confidence in their shared euro currency bloc. They agreed to set up a single banking supervisor to keep bank bailouts from bankrupting countries and made it easier for troubled countries to get bailout help.

Those steps helped calm financial markets, which have expected the ECB to follow up with more help in the form of a rate cut.

The cut in the refinancing rate could mean lower borrowing costs for banks, businesses and consumers. The rate is what banks pay the ECB for loans and through them influences many other rates in the economy. In theory cheap borrowing makes it easier for businesses and people to decide to spend, but some economists say it may have little effect since interest rates are already very low.

The ECB also cut its overnight deposit rate — what it charges banks for depositing their money with the ECB overnight — to zero. Cutting the rate to zero eliminates already paltry returns and increases the incentive for banks to lend that money to each other or to businesses rather than park it with the ECB.

However, cutting the rate to zero does not eliminate the reason banks are often reluctant to lend to each other: fear that other banks may become insolvent and not pay the money back.

Lending activity has remained weak because businesses are not asking for credit because of the slow economy and out of fear that the eurozone may suffer a further financial calamity. Concerns remain that bankrupt Greece could eventually leave the euro, causing more turmoil, or that Spain and Italy could need bailouts that would strain the resources of donor countries.

The ECB move was accompanied earlier in the day by monetary stimulus in China and the UK.

The Bank of England decided to purchase another 50 billion pounds in government bonds from banks, increase the money supply in the UK economy. The hope is the banks will use the extra cash to lend to businesses and households.

China's central bank, meanwhile, cut interest rates for the second time in a month to shore up its economy, the second-largest in the world. Interest on a one-year loan was reduced by 0.31 percentage points to six per cent effective Friday. Chinese authorities have rolled out a series of stimulus measures since March after economic growth slowed to a nearly three-year low of 8.1 per cent in the first quarter.

In the US, weak economic indicators have raised speculation that the US Federal Reserve may also have to do more to keep the US economy growing. Some think the Fed might carry out a third round of bond purchases aimed at increasing the supply of money in the economy -- so-called quantitative easing.

The Fed took more limited action at its meeting ending June 17, extending its so-called Operation Twist effort in which it sells short-term bonds and buys longer-dated issues to push down long term interest rates. The Fed meets next August 1.

The economy in the 17 countries that use the euro is expected to shrink by a relatively mild 0.3 per cent according to EU predictions. But recent data indicate the downturn could be worse. Business sentiment is dropping even in Germany, Europe's biggest and strongest economy.

A bigger drop in eurozone output would make it harder for indebted countries to pay off maturing debt and convince bond investors to keep lending them money. Debts get larger compared to the size of the economy as output shrinks, while growth reduces the relative size of debt and increases tax revenues governments can use to meet their obligation.

The 2 1/2 year old eurozone crisis has seen Greece, Ireland and Portugal need bailouts from the other eurozone countries and the International Monetary Fund to keep paying their debts and covering ther budget deficits. Spain has asked for as much as (euro) 100 billion in rescue loans for its banks.

Markets rebounded after last week's summit where European leaders took several steps to strengthen the shared euro currency and solve their crisis over too much government debt in some countries.

They made it easier for indebted countries to get bailout loans and eased the way for Europe's bailout fund to buy their bonds in the open market, which is one way of lowering borrowing costs. They also agreed to work on creating a common banking regulator that would take the financial risk of bank bailouts off governments.

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