By Johanna Treeck
FRANKFURT (MNI) – The fresh escalation of the Eurozone sovereign
debt crisis will likely thwart any hope the European Central Bank had of
announcing on Thursday a further downsizing of its emergency liquidity
operations for early 2011.
Recent public comments by ECB policymakers had hinted at further
exit moves, but they came before an unexpectedly negative market
reaction to Sunday’s Ireland bailout news, which has seriously
exacerbated market tensions and is likely to be a game-changer for the
ECB.
Nobody should fall for Vice President Vitor Constancio’s assurance
last week that the Irish crisis and the ECB’s exit “are not connected,
of course.” Given rising contagion risks — with more and more countries
beginning to show the first symptoms of the virus — it seems unlikely
the ECB will want to risk upsetting markets even more with the kind of
signal that a new exit step would send.
Clearly, investor worries about sovereign EMU debt have spread in
recent days beyond the most vulnerable member states. Latest bond
indicators from Bank of New York Mellon’s iFlow data on Tuesday showed
that within the Eurozone, Italian fixed income instruments were
subjected to the strongest net selling, overtaking Spain, Portugal and
Ireland. Investors are also divesting their bond holdings in Finland,
Belgium, Greece, Austria, France and even the Netherlands.
Today, however, spreads on all peripheral debt have tightened on
reported large-scale bond purchases by the ECB. The tightening, however,
is also due at least in part to growing market expectations that the ECB
could signal on Thursday a more generalized increase in the scale of its
bond buying program. That remains to be seen, but Trichet seemed to drop
a hint in that direction on Tuesday during an appearance in the EU
Parliament.
At the very least, the central bank is increasingly unlikely to try
and reduce excess liquidity at a time like this. In addition to sending
a disruptive market signal, further exit steps could also pose a
liquidity crunch risk for banks that are still reliant on ECB funding.
The recent surge in 3-month ECB loan demand and in emergency borrowing
from the ECB suggests life has gotten harder again for the weak banks
that are mainly based in the periphery (though there are some in Germany
and other “core” countries as well).
It could be argued that the E10 billion in bailout money earmarked
for immediate Irish bank sector support gives the ECB more room to
withdraw its own support. But there is no guarantee that amount will be
enough to give other euro area banks the confidence to lend again to
their Irish counterparts. And it certainly does not offer any guarantees
to Spanish or Portuguese banks, which according to the Portuguese
central bank may face “intolerable risk.”
The ECB has never been expected to phase out more than the
fixed-rate full-allotment procedure for 3-month operations, arguably
leaving banks with plenty of liquidity access via full-allotment weekly
and monthly refis. Still, it is possible that granting banks generous
terms only on short-term money would give them too little planning
security, risking fresh financial market turmoil at this delicate
juncture.
True, not pursuing the long-flagged exit in 1Q 2011 bears the risk
of potentially undermining the central bank’s credibility.
The ECB may also want to act now to show Eurozone governments that
it means business and that they must get serious about consolidating
public finances and sorting out undercapitalized banks. Moderate bond
buys – at least until the most recent flare-up – was a signal from the
ECB intended to keep the heat on governments.
The question is how far the central bank is ready to go in this
game of brinkmanship, and recent history suggests that it is not very
far. When push came to shove — be it on collateral rules, liquidity
provision or government bond buys — the ECB has always been ready to
reverse course to safeguard Eurozone stability.
Still, with 3-month Euribor rates exceeding the 1% borrowing cost
offered by the ECB, maintaining a fixed rate full allotment for those
operations bears real risks. It would discourage interbank lending and
prevent further normalization for the overall much healthier banking
system, while raising the chances of excessive risk taking.
Concerns over such developments appear to be rising among some
policymakers who have stepped up their warnings against keeping
liquidity measures and loose monetary policy in place for too long.
While they may be keen to keep the Eurozone together, some more hawkish
Council members could be starting to doubt whether it is worth doing so
at all costs.
The ECB may yet announce a compromise solution by ending fixed-rate
full-allotment for 3-month operations while still offering support to
addicted banks. During the last press conference, President Jean-Claude
Trichet confirmed that the ECB is looking at various alternatives.
One option would be to introduce a two-tier system in which weak
banks could still receive unlimited 3-month funding in separate
operations, perhaps at a penalty rate. Another option would be for
national central banks to provide emergency credit lines as Ireland’s
central bank did recently for Irish banks and the Bundesbank did for
Hypo Real Estate in 2008.
Thus far, however, Council members have not dropped any concrete
hints of what a support mechanism for weak banks might look like. This
may suggest that they do not have an effective solution ready to
announce on Thursday.
Another drawback of introducing a two-tier liquidity framework is
that it would highlight the increasing difficulties of setting a common
policy for the Eurozone. Although a few weak banks from core countries
should benefit from such a scheme, parallels might quickly be drawn to
the setting of monetary policy for a two-speed Europe. This would
bolster the argument of those who insist the Eurozone is no longer
viable, thus only serving to ratchet up tensions.
This is especially true given that new ECB staff forecasts for the
Eurozone, due to be released Thursday, will likely be revised upwards
again on the strength of a booming Germany, even as peripheral Eurozone
countries remain mired in recession or stagnation. Setting sound
monetary policy for the region as a whole is indeed becoming an
increasingly daunting task.
–Frankfurt newsroom +49 69 72 01 42; Email: jtreeck@marketnews.com
[TOPICS: MT$$$$,M$$EC$,M$X$$$,M$$CR$,MGX$$$]
