ECB Moves to Prop Up Italy, Spain

The Wall Street Journal

By BRIAN BLACKSTONE And MARCUS WALKER

FRANKFURT—The European Central Bank signaled it would purchase government bonds of Italy and Spain on a large scale, in the most dramatic and controversial escalation of its nearly two-year effort to stem Europe's unfolding debt crisis.

ECB intervention to prop up Italy and Spain is a watershed in Europe's handling of the financial crisis. The central bank has so far insisted that the main responsibility for action lies with national governments. A decision to buy Italian and Spanish bonds is tantamount to conceding that the euro's member states are unable or unwilling to respond effectively, turning the ECB into the lead firefighter—and the euro zone's lender of last resort. That could reshape the future of Europe's monetary union.

The ECB said it will "actively implement" its bond-purchase program, which had been mothballed for more than four months before officials resumed purchases of Irish and Portuguese bonds last week.

The ECB statement, released late Sunday, didn't specifically mention Spanish and Italian bonds. But the implication was clear: after more than one year of on-and-off activity in the bond markets of its weakest countries, the ECB is acting to keep the Greek debt crisis from engulfing its biggest economies.

The statement praised Italy and Spain, the region's third and fourth-largest economies, for "new measures and reforms in the areas of fiscal and structural policies."

Those countries have seen their borrowing costs soar in recent weeks to above 6%. Although well below ten-year bond yields in Greece, Ireland and Portugal, that is seen by analysts as a borrowing rate that Rome and Madrid can't sustain for long, given the amount of new bonds they need to issue.

The ECB move "buys a significant amount of time" for Spain and Italy, and the central bank's statement "clearly points in the direction of an imminent and forceful response," said analysts at Royal Bank of Scotland in a research note.

Yet the decision will be hotly debated both inside and outside the ECB.

The 23-member ECB board was already divided along north-south lines on limited purchases of Irish and Portuguese bonds at the ECB's meeting last week. At least three central bankers from Northern Europe, including the ECB's powerful German contingent, resisted the move, according to a person familiar with the matter.

The decision to expand purchases to Spain and Italy likely split along similar lines. Friday's decision by Standard & Poor's to strip the U.S. of its triple-A rating strengthened the pro-buying faction amid worries about a new bout of contagion sweeping global markets. The ECB tried last week to shore up confidence by buying bonds of Ireland and Portugal, but the move had little impact.

Those countries, along with Greece, are already under European rescue packages, effectively removing them from private-sector markets for financing.

            To meaningfully stem contagion to Spain and Italy, the ECB will have to significantly ramp up its bond purchases, most analysts say—a step it has been reluctant to take. It has purchased fewer than €80 billion of Greek, Irish and Portuguese bonds since the program began in May 2010.

Italy and Spain together issue roughly €600 billion of government bonds a year. According to BNP Paribas economist Paul Mortimer-Lee, "respectable arguments can be made for €230 [billion] to €400 billion of purchases."

Opponents have plenty of ammunition too. Buying government bonds puts the ECB perilously close to supporting fiscal policy, a particular concern in Germany.

Euro-zone politicians engaged in an aggressive campaign over the weekend to spur the ECB into action. "I am calling first and foremost on the sense of responsibility of the European Central Bank. Guardian of the euro, she must intervene massively on the debt market to avoid the implosion of the zone," French Socialist presidential candidate Martine Aubry wrote in the French newspaper Liberation.

Such comments put the ECB in an awkward position. Even if its decision to buy Italian and Spanish bonds is intended purely to improve monetary policy, the decision could be seen as a concession to politicians.

A more practical argument against the move: there is little evidence that buying bonds even works as a crisis-fighting tool. Despite ECB purchases of their bonds, Greece, Ireland and Portugal all have junk-bond ratings, in addition to being in EU-IMF rescue bailouts. Greece is on the cusp of default, despite the ECB's help.

The ECB hopes that Europe's €440 billion crisis fund, the European Financial Stability Facility, will soon take over bond-buying responsibilities. European leaders agreed to give the EFSF the power to buy bonds last month, but the decision still has to be ratified by parliaments.

The ECB "equally considers fundamental that governments stand ready to activate the (EFSF) in the secondary market," the central bank said.

But many analysts say that, at its current size, the EFSF doesn't have the firepower to shield Spain and Italy. RBS economists estimate that around €850 billion of Italian and Spanish bonds must be bought to alleviate pressure in their bond markets. "The risk of political fallout will be large," RBS warned.

Bigger euro bloc countries such as France may balk at increasing their exposure to the region's fragile periphery through an expansion of the EFSF.

The stakes are huge for ECB President Jean-Claude Trichet, whose legacy depends in large measure on how the euro crisis unfolds. Mr. Trichet, 68, is in the final three months of his eight-year term.

The Frenchman has taken great strides to run the ECB in the classic German Bundesbank fashion: rigid adherence to anti-inflation monetary policies and a conservative, balanced-budget approach to fiscal policy while zealously defending the ECB's independence from political pressure.

If buying Spanish and Italian bonds stops the debt crisis at the border of the euro bloc's large economies, then his mix of conservative interest-rate policies with flexibility in responding to crises could prove a lasting template long after he retires.

If it fails, Mr. Trichet will leave with the future of the euro, a project for which he has toiled much of his career, in doubt.

Write to Brian Blackstone at brian.blackstone@dowjones.com