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Europe's central bank and the euro crisis - Draghi strikes back II

2012-03-01 05:45:59

Feb 29th 2012, 12:56 by P.W. | LONDON

AT LAST the waiting has ended. Over the past few weeks the markets have been

obsessing over just how much liquidity banks would tap from the European

Central Bank (ECB) in the second of its extraordinary three-year LTROs

(long-term refinancing operations).

The answer came on February 29th from the Frankfurt-based central bank of the

17-country euro area. The ECB announced that it had lent 530 billion ($710

billion), a bit more than traders had expected. The funding also exceeded the

previous LTRO, in late December, which had already provided a massive 489

billion. The number of banks dipping into the honeypot reached 800, well above

the 523 that borrowed in the first operation.

Just as sequels rarely match the success of blockbuster movies, so with the ECB

s second funding operation. For one thing, since the amount was only a bit

higher than expectations, it should broadly be priced into the markets (though

such rationality should never be taken for granted). For another, more of the

take-up is likely to have come from banks outside the euro area.

More important, the first three-year LTRO proved a runaway hit because the ECB

showed its hand or rather that of the wily Mario Draghi, who had taken the helm

only weeks before, replacing Jean-Claude Trichet, the bank s previous

president. No, Mr Draghi clearly signalled, the ECB under his leadership would

not become the lender of last resort to troubled governments. Instead, it would

become the lender of first resort to troubled banks, which could in turn prop

up toppling sovereigns by purchasing their debt. Moreover, it would provide

funds for a record length (LTROs are usually for months rather than years and

the previous record was just one year) and at dirt-cheap rates (the three-year

average of the ECB s main policy rate, currently at 1% and tipped to fall later

this year to 0.5%).

The ECB s eleventh-hour intervention in December dampened down the euro crisis,

which had threatened to go critical. Italian and Spanish government bond yields

had soared and scared investors had shunned European banks, causing an ominous

funding drought. The first three-year LTRO broke this spiral of pessimism by

removing fears of an imminent banking implosion.

As confidence returned, funding markets re-opened for stronger banks in

stronger European economies. And crucially, the ECB s backdoor approach worked

a treat in Italy and Spain. Banks there lapped up the central bank s funds and

purchased their own governments debt. That pushed down Italian and Spanish

sovereign bond yields whose spreads over German Bunds narrowed markedly.

At best, the second LTRO will maintain that return of confidence for a while.

But the ECB s provision of liquidity buys time rather than solving the euro

area s deep-seated problems, which are as much political as economic. A sharp

reminder of the dangers ahead came on February 28th when Enda Kenny, the Irish

prime minister, unexpectedly announced that Ireland would hold a referendum on

the European treaty to enshrine budget discipline in national law. Even if the

Irish vote against it, the fiscal compact will take effect, since it requires

only 12 countries in the euro area to back it. But the referendum will reveal

public resentment against the harsh austerity that has been imposed on Ireland

under its bail-out.

There are other tripwires ahead, highlighted by this week s decision by

Standard & Poor s, a credit-rating agency, to put Greece into selective

default as a result of the debt-exchange deal that will slash the face value

of private-sector holdings of Greek public debt by more than half. A vote in

the German parliament endorsed the linked second bail-out of 130 billion, but

opinion polls revealed that over 60% of Germans were opposed to it. Even if the

debt swap goes according to plan, an election in April could move Greece closer

to an exit from the euro area, with potentially forbidding consequences not

just for Greece but the rest of the single-currency zone.

Perhaps most worrying of all, the economic prospects are not just bleak for

bailed-out and beleaguered Greece and Portugal but also for much larger Italy

and Spain. Italian and Spanish borrowing costs may have fallen but that will be

of little avail if these economies, already forecast to shrink this year, are

unable to return to growth. Moreover, the austerity that Spain must undergo is

fiercer than had been expected since its deficit last year has turned out to be

8.5% of GDP rather than the 6% that had been targeted.

The ECB s second dollop of easy money has comforted markets. But the euro

crisis has not gone away. It would not take that much for it to turn acute

again.