Draghi takes over ECB as eurozone mess worsens

[November 03, 2011]  FRANKFURT, Germany (AP) -- Mario Draghi holds his first press conference as new head of the European Central Bank under pressure to signal it will continue buying government bonds to keep Europe's debt crisis from worsening.

A surprise interest rate cut has also not been ruled out as Draghi takes over. He faces an array of problems: weakening growth, excessive inflation and uncertainty over whether a bailout for heavily indebted Greece will go through or be derailed by a proposed referendum.

Markets are waiting to see if Draghi will be more aggressive in supporting troubled governments than predecessor Jean-Claude Trichet, whose eight-year term expired.

The bank's program to buy government bonds drives down the borrowing costs that Italy and Spain face in bond markets. High interest rates on borrowing drove Greece, Ireland and Portugal to take bailout loans from other eurozone governments.

Under Trichet's leadership, both he and Draghi, a former World Bank director and top Italian official, stressed that the program was temporary and that the new eurozone bailout fund needs to be ready to step up and take the purchases over. The fund won't finish arrangements to leverage its limited financial resources until next month at the earliest, however.

That has left the ECB as the last line of defense in the bond market -- a position it has been uncomfortable holding. Trichet limited his comments on the program, and markets want to see if Draghi will open the door to more aggressive purchase.

"Draghi's attitude to the ECB's program of buying distressed government debt will be of prime importance," said Jane Foley at Rabobank. "Today's press conference will be no doubt used as an opportunity to test his resolve on this issue."

Those expecting a more aggressive stance on bond purchases and a signal for a rate cut may be disappointed as Draghi may choose to stress continuity at the bank, wrote Unicredit economist Marco Valli. "We think Draghi will be very much in agreement with Trichet" and will signal that the bond purchases are a temporary measure, he wrote.

The bank's key rate stands at 1.5 percent after increases in April and July aimed at warding off inflation. Since then the economic outlook has worsened significantly for the 17 countries that use the euro, leading many analysts to think the bank will cut rates in December or early next year. A rate cut Thursday has not been ruled out.

Inflation at 3.0 percent -- well above the bank's goal of just under 2 percent -- gives a reason to hold off. Rate cuts spur growth but can worsen inflation.

Draghi will also face questions about Greek Prime Minister George Papandreou's proposal to hold a referendum on Greece's bailout, part of a broader plan to halt the crisis agreed upon at a summit last week but already in danger of unraveling.

Greece is to get euro100 million ($138 million) in more bailout financing to avoid a disorderly default on its bonds that could damage Europe's banks and choke credit to the wider economy. But it comes with painful conditions and Papandreou says he wants the people to decide despite being told that no more bailout money will be forthcoming from other eurozone governments until the result is clear.

Papandreou faces a confidence vote Friday and it's not clear the referendum will take place.

Critics of bond purchases argue that they take pressure off politicians to get their budget deficits down.

The issue is pressing, with Italian bond yields at an elevated 6.3 percent. Earlier, the ECB purchase program had driven them under 5 percent. But fears of more turmoil in Greece, and a perception that Italy is not acting quickly to cut spending and improve growth have put more pressure on its bonds.

But some economists have argued that only the ECB can act quickly and forcefully enough to backstop troubled governments and contain the crisis. Europe's bailout fund is considered too small, at euro440 billion, despite proposals agreed last week by eurozone leaders to increase its financial firepower to euro1 trillion by letting it insure part of the value of government bond issues.

Key details of how the bailout fund would do that have not been filled in, and the initial burst of market relief over the idea has faded. Eurozone officials also worked out plans to cut Greece's debt burden by 50 percent and to push banks to increase the size of their financial cushions against any losses or further market plunges that might result from that.

The ECB has potentially unlimited firepower, backed by its ability to create new money -- an ability the U.S. Federal Reserve and Bank of England have used. The ECB has been unwilling to do that. When it buys government bonds to stabilize their market price, it withdraws an equivalent amount of money from circulation to avoid creating inflation.

[Associated Press; By DAVID McHUGH]

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