ECB’s bazooka has a limited shelf life

August 8, 2011

By Peter Thal Larsen
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Did Standard & Poor’s spur the European Central Bank into action? There was no direct link between the rating agency’s decision to strip the United States of its triple-A status and the euro zone debt crisis. But fears of market turmoil triggered by the downgrade may have prompted the central bank to restart its bond-buying program. The intervention has calmed nerves. However, it is only buying time.

The ECB would have preferred euro zone governments to step in. However, they cannot do so until the European Financial Stability Facility is given the authority to buy sovereign debt in the secondary markets — a process that will take several months. With Italian and Spanish government bond yields soaring, and most of Europe’s politicians on holiday, the ECB rode to the rescue.

Quite how big that rescue is remains to be seen. On paper, the ECB’s Securities Markets Program is unlimited. By being ambiguous about the size of its chequebook, the central bank could bully markets into accepting much lower yields. But making a dent will require a big outlay: Italy alone still has to issue debt worth about 100 billion euros this year.

Besides, the ECB has so far insisted on sucking in bank deposits to neutralize the effects of buying around 74 billion euros worth of Greek, Irish and Portuguese debt. Unless the central bank decides to effectively start printing money, this will limit its ability to buy bonds in much larger quantities. The prospect of intervention helped drive down Spanish and Italian bond yields on Aug. 8 — though in both cases yields on 10-year bonds are still higher than they were a month ago.

In the meantime, the ECB is open to other risks. One concern is that its intervention will relieve the pressure on Italy to stick to its deficit-cutting measures. The expansion of the EFSF could also be derailed if one euro zone member fails to approve it.

Finally, the EFSF itself may not be up to the task. Reforms to the bailout facility are designed to increase its lending capacity to 440 billion euros. That’s enough to finance the current Greek, Portuguese and Irish bailouts, recapitalise Spain’s banks, and buy all the bonds that Spain and Italy still plan to issue this year. However, it cannot afford a full Italian bailout.

Besides, the EFSF’s ability to borrow depends on the guarantees provided by euro zone members — particularly those with triple-A credit ratings. There is no direct reason why the U.S. downgrade should trigger similar steps in the euro zone — but it does make France’s membership of the triple-A club look increasingly shaky.

A French downgrade would force Germany to guarantee an even larger part of the bailout fund — or force the EFSF to accept a lower rating and higher borrowing costs. This would further complicate the rescue. Still, given the U.S. experience, the euro zone would be in good company.

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