FRANKFURT (MNI) – Wednesday’s record liquidity injection of almost
half a trillion euros worth of three-year money into the Eurozone’s
banking system should ease the European Central Bank’s credit crunch
fears, but it may do little to alleviate sovereign debt market tensions.

Amid concerns that money market tension and recapitalization
pressures could starve the real economy of credit, the ECB had actively
encouraged banks to bid for ultra-long loans at cheap rates of 1%.

Total demand of E489.19 billion easily surpassed the consensus
forecast of E250 billion to E300 billion and the previous record
allotment of E442 billion in the ECB’s 1-year LTRO of June 2009.

Long-term liquidity “should ensure that banks continue to have
access to stable funding, also at longer maturities, which gives them
the opportunity to continue lending to firms and households,” ECB
President Mario Draghi said earlier this week.

Analysts generally agree that the strong uptake is a positive omen
for bank lending to the real economy. They are less confident that banks
will turn around and invest their cheaply acquired ECB funds in higher
yielding government bonds, which would help ease debt market tensions.

ECB policy-makers did not express any explicit desire in their
public comments for a massive carry trade in which banks would snap up
large volumes of sovereign bonds. But they do hope that the profit
opportunities they have created might offer the ECB an escape from the
kind of aggressive debt market interventions being urged by many market
participants, economists and politicians.

Coupled with the possible positive impact of Eurozone governance
reform efforts currently underway, and a boosted IMF, more demand from
European banks for government debt might substantially ease funding
costs on Italy’s bond redemption in February. That could mark a
turnaround in the crisis and ensure that the ECB would not need, against
its better judgment, to ramp up its bond buying program.

However, analysts and private bankers are skeptical that there will
be a repeat of the June 2009 tender, after which about half the funds
were used to exploit interest rate differentials between the ECB refi
rate and government bond yields.

Given the European Banking Authority’s new capital ratio
requirements, fears of a default in the Eurozone, and bank shareholders’
wariness of sovereign debt holdings and the cost of hedging them, such
carry trades will not be as common this time around, they argue.

The Italian Banking Association on Wednesday warned that “banks not
only will not increase their exposure [to sovereign bonds], but they
will probably cut it.” The EBA’s new rules, requiring banks to set
aside a temporary capital buffer against sovereign debt that is marked
to market, has made government bonds “the new toxic assets, in the eyes
of the markets,” the association said.

Comments by Draghi, who hinted Sunday that the EBA might take a
lenient stance on the new capital requirements in the face of a looming
credit crunch, suggest that these concerns may be somewhat exaggerated.

The extent to which Italy’s E63.5 billion worth of bond redemptions
in February and early March could bring lower borrowing costs and mark a
turning point in the crisis, will also depend on the developments in the
real economy.

Italian GDP data, released Wednesday, does not bode well. The
economy contracted in the third quarter by 0.2% q/q. Confidence
indicators have been pointing further south in 4Q with significantly
weaker global growth, high economic uncertainty, and sharp fiscal
tightening expected to weigh on activity in the months ahead.

The new government under Mario Monti is drawing up polices aimed at
boosting growth, which will likely rely primarily on structural reforms.
The Italian leadership will have to act quickly and decisively to ensure
that markets consider the plans credible and give them time to
accomplish their objective.

The negative feedback loop between the debt crisis and the real
economy is increasingly threatening the potentially positive effects of
adjustment efforts. The International Monetary Fund on Tuesday
significantly slashed growth forecasts for Portugal and Ireland.

The headwinds coming from weaker global economic growth could even
push Ireland, the model bailout student, off track, the IMF warned. “In
these more adverse circumstances, further strengthening of European
support for Ireland’s recovery would reinforce prospects for program
success,” it said.

Ensuring that the Eurozone’s economies will not face the additional
burden of sharply tighter credit conditions is certainly a step in the
right direction. Whether the massive liquidity injection will indeed
pave the way for a turnaround of the crisis is far from certain.

–Frankfurt newsroom +49 69 72 01 42; e-mail:

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