ECB Held Hostage By Europe's Sovereign Debt Crisis

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European Central Bank (ECB) President Jean-Claude Trichet earlier this year resisted pressure to intervene when Greece's budget deficit spurred investor concerns about the viability of the Eurozone and its single currency, the euro. But a bond market sell-off forced Trichet's hand and the ECB began purchasing government debt.

Now budget deficits in Ireland, Italy, Portugal, and Spain – the remainder of the so-called "PIIGS" – have again forced Trichet and the ECB out of their comfort zone. After signaling last month that the ECB could start limiting access to its funds, the central bank yesterday (Thursday) said it would delay its withdrawal of emergency liquidity measures.

"Uncertainty is elevated," Trichet told reporters after meeting with the ECB's Governing Council. "We have tensions and we have to take them into account."


The ECB left its benchmark lending rate at 1.0% for the 20th consecutive month and will offer banks unlimited loans through the first quarter over periods of seven days, one month and three months. However, the central bank resisted pressure to announce another major bond buying program.

Some European policymakers such as Spanish Industry Minister Miguel Sebastian had hoped the ECB would take on more government debt.

It would be "more than reasonable" for the ECB to buy Spanish government bonds, as it's "within the orthodoxy" of central bank policy as dictated by the actions of the U.S. Federal Reserve and Bank of England, Sebastian said yesterday.

But to increase bond purchases would mean taking more risk onto the ECB's balance sheet, something the central bank is loathe to do. The ECB also wants European politicians to take responsibility for their countries' debts, and avoid the appearance of being a bailout tool for the continents' governments.

"The ECB really wants to focus on its core business but it's not being allowed to," Nick Kounis, chief euro-region economist at ABN Amro NV in Amsterdam, told Bloomberg. "The politicians need to get their act together but until they do, the ECB is left trying to carry the show with these sort of facilities, which are no solution to the problem."

At this point, any indication that the ECB is even considering tightening its policy or withdrawing liquidity could upset financial markets that have already been roiled by soaring sovereign debt in Europe.

A $112 billion (85 billion-euro) bailout for Ireland failed to reassure markets on Sunday as attention has shifted to looking at which country might be next to need help. Portugal, Spain, and Italy are among the most likely candidates.

Italy's public debt stands at nearly 120% of gross domestic product (GDP) and is on the hook to refinance $370 billion (280 billion euros) of government debt next year. The country's 10-year borrowing cost on Tuesday rose to a one-year high of 4.75%.

"Italy has become a concern because the economy is not growing fast enough to keep up with the public debt," Giacomo Vaciago, professor of political economy at the Catholic University of Milan, told The New York Times. "With a deficit of 5% of GDP, and growth of 1%, the fear is that you will never reverse your budget balance, and therefore the common judgment is that sooner or later Italy could default."

Italy's failure would be catastrophic, more so than the collapse of the smaller economies of Greece and Ireland.

Still, "the market is looking at every country, and the moment there is some weakness, they're attacking it," Steven Vanneste, an economic advisor at BNP Paribas Fortis, told The Times.

Portugal's debt amounts to 76% of GDP, compared with 53% in Spain, 66% in Ireland and 116% in Italy last year.

Portugal has promised to cut its fiscal deficit to 7.3% of GDP this year from last year's 9.3%, the fourth-largest shortfall in the euro region. For 2011 it has an even more ambitious goal of 4.6%. However, the country is expected to fall into recession next year after posting a sluggish 1.3% growth in 2010.

Meanwhile, Spain's public deficit is expected to total about 9.3% of GDP this year, but its economy is expected to grow by just 0.7% in 2011.

Greece's economy is expected to shrink again but by less than in 2010.

ECB President Trichet has said he does not oppose governments increasing the size of the European Union's (EU) $989 billion (750 billion-euro) emergency fund, and he has left the door open for future bond purchases.

Still, he remains optimistic that European governments will take responsibility for their economies without further assistance.

"We are calling… not only for governments to behave properly, but also for banks. They should — with the help of the governments if and where necessary — restore the solidity of their financial structure and their balance sheets," he said in an interview with  The Wall Street Journal. "I also said that our nonstandard measures were temporary by nature. As you know we could eliminate some nonstandard measures in the past — in being commensurate to what we were observing in the market — and it worked. At the present moment — taking into account the entire situation — we have decided, what we have decided."

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