All eyes on ECB's Draghi to fight crisis

[July 31, 2012]  FRANKFURT, Germany (AP) -- European Central Bank president Mario Draghi has already taken Europe's monetary authority into uncharted territory.

Now, with the debt crisis in Europe threatening further disaster, he may have to push it even farther into the unknown to save the euro.

The 17 countries that use the euro are struggling as economies across the region face deepening recessions. Spain and Italy, the two chief trouble spots, are threatened with a financial collapse that could tear the 13-year old currency union apart and rock the global economy.

Spain's bond borrowing costs, or yields, have hit record highs recently as it tries to prop up its stricken banking sector and meet requests for financial aid from its regional governments. That has raised fears the country may be the next to seek a bailout from the other eurozone countries, following Ireland, Greece, Portugal and Cyprus. Italy, attempting to keep a handle on its debts in a stagnant economy, is also feeling the heat.

Then last Thursday, Draghi sharply raised expectations for more central bank action when he vowed the ECB would do "whatever it takes" to save the 17-country euro, and that "believe me, it will be enough." Markets jumped on the news, expecting that the bank could soon intervene in bond markets to drive down the borrowing costs that are threatening Spain and Italy.

In the days following Draghi's comments, politicians across Europe have added their voices to pledges of action for the eurozone. First came a joint statement from Angela Merkel of Germany and France's Francois Hollande, followed by another from Merkel and Italy's Mario Monti. This was followed by the head of the eurozone's finance ministers group, Jean-Claude Juncker, and German finance minister Wolfgang Schaeuble.

All eyes are on Draghi to see what the ECB can deliver.

Yet Draghi and the 23-member governing council face a key constraint: they must contend with the demands of fear-stricken financial markets on one side and its founding treaty on the other.

The 1992 treaty gives the bank an overriding mandate to control inflation first, and only then to seek other goals such as growth. It is forbidden from supporting the finances of eurozone governments. That's different from other central banks, such as the U.S. Federal Reserve and the Bank of England, which have broader crisis-fighting powers.

The Fed is meeting this week and could decide to take more action to stimulate a weakening economy.

How far can Draghi go? The bank also has a meeting this week but could act at any time. Here are some possibilities -- and their drawbacks:

BUY GOVERNMENT BONDS:

Buying bonds drives up their prices, and pushes down their interest rates -- or yields. That's because prices and yields move in opposite directions. Starting in May, 2010, the ECB intermittently bought more than (EURO)200 billion worth of bonds of shaky governments including Italy and Spain, on the open market.

DRAWBACK: The effort did not do much to calm the crisis. Its impact was blunted because the ECB stressed it was limited in amount and focused only on spreading the ECB's interest rate policy throughout the eurozone. It is opposed by some, including Germany's Bundesbank, which has a seat on the ECB's board, as blurring the bounds between influencing interest rates -- the ECB's job- and helping government finances, which it can't do.

Europe's temporary bailout fund, the European Financial Stability Facility, could buy bonds -- but has limited resources on its own.

TURNING THE BAILOUT FUND INTO A BANK:

By agreeing to a banking license for the European Stability Mechanism, the bailout fund set up by the countries that use the euro, the ECB would enable the fund to borrow from the ECB and use that money to buy the bonds of troubled governments from investors on the open market.

Because the ECB can create as much money as it wants in order to lend, the ESM could in theory raise several trillion euros if it had to. And because the ECB is not helping out governments directly, it can be argued the practice would not fall foul of the treaty.

"That is the No. 1 concrete thing they could do," said Karl Whelan, an economist at University College Dublin and former staff economist at the Federal Reserve. "There is nothing illegal about it. People would stop staying the eurozone doesn't have the firepower to fund Spain and Italy. It would be the end of that concern."

DRAWBACK: Nonetheless, Draghi and others say the idea is still too close to financing governments. He made a forceful statement July 5 that the move would violate the ECB's mandate and would mean violating its mandate, thus "destroying its credibility."

Still, the ECB has reversed course on other issues during the crisis.

LEND TO BANKS:

The ECB could expand its lending to banks for short-term loans. It would do that by agreeing to ease its rules on what types of collateral it could take for banks for these loans. It has already done this several times before and also given banks unlimited credit.

It could also make a third offer of cheap, three-year loans to banks, after two rounds that handed out (EURO)1 trillion in December and February. Some banks used the money to buy government bonds. That's allowed under the ECB treaty because the ECB can loan any amount to banks -- just not to governments.

DRAWBACK: Banks holding too much government debt is already one of the key risk factors in the crisis. A government default would hurt banks and cut off lending to the wider economy. More lending could make that worse.

CUT RATES:

Analysts say the ECB has room to cut the main refinancing rate it charges banks for loans from the current all-time low of 0.75 percent. It could also push the rate it pays banks for deposits -- currently zero -- into negative territory, a move aimed at pushing them to lend funds rather than stash them with the ECB. This could help bolster currently weak growth -- which would help government tax revenues and make it easier to pay debts -- and lower costs to shaky banks.

DRAWBACK: Rates are already very low and it's not having much effect on business activity and borrowing.

Jonathan Loynes, chief European economist at Capital Economics in London, says Draghi's remarks last week were a "pretty strong signal" the bank might intervene in government bond markets with limited purchases aimed at lowering countries' borrowing costs, as it has before on a limited basis. Markets, however, appear to hope for that plus more, a comprehensive new approach.

"My guess is, the markets will be disappointed," Loynes said. "There was a lot of emphasis on those three words, 'Whatever it takes.' "But there are three other words that are just as important: 'Within our mandate.'"

[Associated Press; By DAVID McHUGH]

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