Running Out of Options, Euro Zone May Face a Stark Choice

Published: Friday, 6 Jul 2012 | 10:51 AM ET

By: Reuters

The European Central Bank is almost out of conventional policy options and will have to turn to measures it finds deeply unpalatable if the euro zone crisis intensifies, or watch the bloc slide towards the abyss.

By cutting its main interest rate by a 1/4 point to a record low 0.75 percent on Thursday and reducing the rate it pays on overnight deposits to zero, the ECB has almost exhausted its normal ammunition. Beyond that are only options it dislikes.

Some economists expect another cut in the main interest rate to 0.5 percent but after that the ECB must essentially employ its balance sheet to help the euro zone economy.

That means buying government bonds — an option opposed by Germany's Bundesbank, the ECB's biggest stakeholder — or else offering more cheap loans and exposing the bank to risks that many of its policymakers already find worryingly high.

"It is very uncomfortable for markets knowing there is a risk there is no more they can do if data deteriorates in the next couple of months," said Nomura economist Jens Sondergaard.

He expected the ECB to cut its main interest rate once more — by another 1/4 point — in August and then hope the euro zone economy would pick up towards the end of the year.

Failing that, the ECB could revive its bond-buying program, which Sondergaard said was "the option that is not acceptable to them at this stage but which might be in the fourth quarter if financial market conditions are bad".

Last week's EU summit measures to tackle the euro zone crisis failed to impress markets, and some economists believe the bloc still faces an existential threat.

Nouriel Roubini, once known as "Dr. Doom" for bearish views predicting the 2008 financial crash, told Germany's Handelsblatt on Friday he would give the euro another three to six months: "Then Italy and Spain will lose access to capital markets."

The euro zone's permanent rescue fund, about to come online, can intervene in the bond market to lower borrowing costs but with maximum funds of 500 billion euros, and up to 100 billion of that already earmarked for Spanish banks, its resources could run thin very quickly.

ECB President Mario Draghi held out the possibility on Thursday that the bank could employ its balance sheet to greater effect, saying it needed to review its collateral framework.

Such a move could see the ECB further loosen rules on the assets banks offer up to tap its loans, giving them greater access to cheap funding.

If it balks at buying bonds the ECB could also repeat its long-term liquidity offer. In December and February it unleashed over 1 trillion euros ($1.24 trillion) into the financial system with 3-year loans, or LTROs, a move it said prevented a major credit crunch.

Some policymakers already have concerns about the collateral risks the ECB has taken onto its balance sheet in return for issuing those LTROs, and Draghi said the Governing Council did not discuss any other such "non-standard measures" on Thursday.

"I will also tell you why we did not discuss that — because we have to have non-standard measures which are effective ... it is not obvious that there are measures that can be effective in a highly fragmented area," he said.

Draghi also poured cold water on a third option — allowing the ESM rescue fund to have access to the ECB's cheap loans, which would dramatically boost its firepower and allow it to intervene with real impact on bond markets, where Spain's benchmark yields have again breached 7 percent.

"I don't think there is anything to gain in destroying the credibility of an institution, asking it to behave outside the limits of its mandates," he said.

Conservative Core
Many ECB policymakers are nervous about the risks to the bank's balance sheet that came with the collateral it accepted in return for the twin, ultra-cheap loans.

They are putting the onus on governments to tackle the crisis, nervous about taking on any further risks.

"There should be no illusion that the ECB can single-handedly ensure a plain sailing for our economies and the markets," ECB Executive Board member Joerg Asmussen said on Friday. "There are limits of what we can do, and what we know."

Earlier this week, Dutch ECB policymaker Klaas Knot said the bank could not continue its emergency operations - measures such as the LTROs - forever because of the risks to its balance sheet.

"The bond-buying program is in a deep sleep, and it will remain there," Knot told Dutch magazine Elsevier.

A core of ECB policymakers feel the bond program - dormant for four months now - amounts to monetary financing of governments, which is beyond the bank's mandate. Last year, Axel Weber, then Bundesbank chief, quit in protest at the plan.

Worried about the potential for some of the collateral it holds to turn toxic, the ECB has already taken some steps that suggest it is entering self-preservation mode.

Earlier this week, the bank set a limit on the amount of state-backed bank bonds that banks can use as collateral in ECB lending operations.

Banks in troubled euro zone countries such as Greece have been increasingly borrowing ultra-cheap funds from the ECB using self-issued bonds which are then given a state guarantee by the government which make them eligible at the ECB.

The amounts involved could be over 100 billion euros.

Central bank policymakers have become increasingly disgruntled by the practice in recent months, worried it could leave the ECB facing big losses if Greece or other countries with banks doing the same left the euro.

The ECB could cope with a Greek exit from the euro zone but the losses this would entail would test the depth of its resources and the political will of its 17 national stakeholders.

If Spain or Italy went the same way the subsequent catastrophic losses could sink the ECB, at the same time as dragging the currency union into the abyss, making both countries essentially too big to fail.

The ECB has little paid-in capital but could turn to its national shareholders to recapitalize it if necessary, although some may not be in a position to do so.

However, between them the ECB and national euro zone central banks have funds of differing descriptions that would theoretically put its total firepower up to around 700 billion euros if all stakeholders met their obligations.

The bigger potential problem is an unknown quantity.

Some experts believe the euro zone's cross-border TARGET2 payments system hides potentially colossal losses which could materialize if a country quits the currency area.

The system reflects the imbalance of flows between deficit and surplus countries, meaning mighty Germany could be overwhelmingly on the hook.

Figures compiled by the University of Osnabrueck in Germany show Greece's TARGET2 liabilities amount to about 100 billion euros. Should Greece leave the euro zone, the status of this liability would be unclear.

The tab that Greece, Spain, Italy and other debt-hobbled countries have run up with Germany's Bundesbank now stands at almost 730 billion euros.

In the event of a country leaving the euro zone, its TARGET2 imbalance would become subject to sovereign debt renegotiations, euro zone central bank officials say, which may leave some euro zone central banks needing to seek fresh capital from their governments.

If it were faced with the risk of such a messy and costly scenario, the ECB would likely act first and compromise its principles to hold the euro zone together.

"If you have data pointing a very significant 2008-style contraction in GDP, inflationary pressures collapsing completely and risks of a euro area break-up, then I really expect the ECB to sacrifice some of their more dogmatic views and say 'we will go all in and do what is necessary'," said Nomura's Sondergaard.

Copyright 2012 Thomson Reuters