Trichet Draws ECB ‘Bazooka’ to Stem Contagion

Bloomberg

By Matthew Brockett and Jeff Black - Aug 8, 2011

European Central Bank President Jean- Claude Trichet signaled he’s ready to start buying Italian and Spanish bonds in his riskiest attempt yet to tame the sovereign debt crisis.

In a statement issued in the name of the ECB president after an emergency Governing Council conference call last night, the Frankfurt-based central bank welcomed the two nations’ efforts to reduce their budget deficits and said it will “actively implement” its bond-purchase program. It also called on all euro-area governments to follow through on the steps they agreed to July 21, including allowing the European Financial Stability Facility to purchase bonds on the secondary market.

With governments failing to act swiftly enough to stop contagion from Greece’s fiscal meltdown, it has fallen to the ECB to battle a crisis that’s now threatening the survival of the euro. Buying Italian and Spanish debt may require the ECB to massively expand its balance sheet and open it to accusations of bailing out profligate nations, breaching a key principle in the euro’s founding treaty. Germany’s Bundesbank opposes the move.

“The ECB is once again intervening as the last line of defense,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. “The intervention will put a halt to the bond-market crash that some member states faced. It will in our view bring an immediate tightening in Spanish and Italian bond spreads of the order of 100 to 150 basis points.”

G-7 Conference Call

The Group of Seven nations welcomes efforts by Spain and Italy to strengthen fiscal discipline, finance ministers and central bank governors of the group said in a statement early today after a conference call.

“No change in fundamentals warrants the recent financial tensions faced by Spain and Italy,” the G-7 statement said. The G-7 also said it will take “all necessary measures to support financial stability and growth.”

Italian and Spanish 10-year yields closed on Friday at 6.08 percent and 6.03 percent respectively. Both reached euro-era records earlier in the week. Italy has 1.8 trillion euros ($2.6 trillion) in outstanding debt.

The euro traded at $1.4350 at 9 a.m. in Frankfurt, up from $1.4277 at the close of European trading on Friday.

Global Rout

ECB policy makers were forced to step up their response to the debt crisis after a failure to enter the Italian and Spanish bond markets last week helped fuel a global rout.

“It looks like the ECB has decided to bring out the bazooka,” said Douglas Borthwick, head of foreign-exchange trading at Stamford, Connecticut-based Faros Trading.

Fears of a further slump when markets open today were compounded by Standard & Poor’s decision on Friday to strip the U.S. of its AAA credit rating for the first time.

Asian stocks dropped today, extending the worst global slump since the bull market began in 2009, with the MSCI Asia Pacific Index down 2.9 percent at 3:21 p.m. in Tokyo. S&P 500 Index stock futures slid 2.4 percent while Euro Stoxx 50 futures declined 1.2 percent.

Since starting its bond purchases in May last year, the ECB has bought about 74 billion euros of assets to help stabilize Greek, Irish and Portuguese markets -- the three countries of the euro area to have received bailouts from the European Union and International Monetary Fund.

Curbing Inflation

Four months ago, the ECB ceased bond purchases and put the onus on governments to find a solution to their debt woes as it turned its attention to raising interest rates to curb inflation. Now it finds itself once again in the vanguard of efforts to overcome the crisis.

Because the ECB will have to spend considerably more to have an impact on the bond markets of the euro area’s third- and fourth-largest economies, it may not be able to continue to sterilize its purchases by absorbing the equivalent amount from banks via term deposits, saidCarsten Brzeski, senior economist at ING Belgium in Brussels.

That would amount to swelling the money supply, or quantitative easing, which may in turn fuel inflation.

“I don’t think that very large volumes -- like 50 billion a week -- can be sterilized,” Brzeski said. “Then they risk throwing their very last principle overboard.”

The ECB, which is also lending banks unlimited amounts of cash at its benchmark rate of 1.5 percent, has always said its so-called non-standard measures are temporary.

Bond Program

Last night it reiterated that the bond program aims to help restore “a better transmission of our monetary policy” and “therefore to ensure price stability in the euro area.”

Cailloux said he expects the ECB to buy on average around 2.5 billion euros of bonds a day, which would amount to about 600 billion euros if maintained over a year. While the ECB may be playing for time until the EFSF is ready to take over bond purchases, between them they may be forced to hold “close to half of the traded Italian and Spanish debt, or around 850 billion euros,” Cailloux said.

While ECB bond purchases have the potential to act as a “circuit breaker,” they are not a solution, said Michala Marcussen, head of global economics at Societe Generale SA in Paris.

“The real solution is for the euro area to move to some form of fiscal union,” Marcussen wrote in a note to clients today. “We see the next step in this process to increase the size of the EFSF to at least 1.5 trillion euros. This will be politically difficult, and all the more so at a time when the most recent adjustments to the EFSF are still pending ratification by national parliaments.”

The 440 billion-euro rescue fund currently has about 323 billion euros left at its disposal.

In a joint statement yesterday, French President Nicolas Sarkozy and German Chancellor Angela Merkel called Italy’s decision to balance its budget in 2013, a year ahead of schedule, of “fundamental importance.” They also called for their parliaments to approve the strengthening of the EFSF by the end of September.

To contact the reporters on this story: Matthew Brockett in Frankfurt at mbrockett1@bloomberg.net; Jeffrey Black in Frankfurt atjblack25@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net