November 14, 2011
As European Nations Teeter, Only Lenders Get Central Bank’s Help
By JACK EWING
FRANKFURT — Is it time for the European Central Bank to be as generous to countries as it is to banks?
Since the beginning of the financial crisis, the central bank has been lending euro area banks as much money as they want, trying to maintain the liquidity — or continual flow of money — that is the lifeblood of the global financial system.
But because the central bank has refused to offer the same easy lending service to countries like Italy and Spain, it is not confronting the euro area’s most fundamental problem — a sell-off of debt from the troubled countries that is pushing their borrowing costs to dangerous levels.
Investors pushed up interest rates on Italy’s debt to record-high levels last week during the political crisis there. And even Monday, after the supposedly calming effect of a new, technocratic prime minister in Rome, lenders were demanding that Italy pay interest rates at levels high enough to eventually bankrupt the country.
In an auction of five-year bonds, Italy had to pay a rate of 6.29 percent, compared with 5.32 percent at a similar auction a month ago.
And Italy’s 10-year bonds, which crested well above 7 percent last week in the secondary market, were still dangerously high on Monday, at 6.77 percent — more than three times what Germany must pay on comparable bonds. In a further sign of investor anxiety about the weaker links in the euro chain, Spanish 10-year bond yields rose above 6 percent for the first time since August.
It is an atmosphere of mistrust reminiscent of the aftermath of the Lehman Brothers collapse in 2008. European banks are demanding higher interest rates for the overnight lending to one another that is essential to keep money circulating.
Still, banks are feeling the pressure to reduce costs and raise capital in the face of Europe’s sovereign debt crisis. Unicredit, the largest Italian bank, said on Monday that it would raise $10.3 billion and eliminate 5,200 jobs in Italy over the next few years as part of a strategic overhaul.
Some banks have even gone so far as to refuse to make overnight loans to other banks at all, fearing others’ vulnerability to the debt of Italy, Spain and other beleaguered countries. For that reason, the central bank has been willing to lend to the banks as needed.
But the biggest fear — the one implicit in all the talk of “contagion” and a potential “Lehman moment” — is not that any one bank will succumb to a liquidity crisis. It is that an entire country might do so, if it can no longer obtain the credit it requires to stay in business.
And at least so far, the central bank has not done the one thing that could help calm that fear: declare that it stands ready to be the de facto lender of last resort to national governments.
If the fear that sent Italy’s borrowing costs to record highs last week becomes a chronic condition, the country could lose the liquidity it needs to keep paying the holders of its 1.9 trillion euro ($2.6 trillion) debt. That would be the Italy Moment — the point at which Rome’s liquidity problem would quickly become everyone else’s.
“We are approaching the point where the E.C.B. has to show its hand and accept its role as a lender of last resort,” analysts at Credit Suisse said in a note to clients Friday. “The question is how much further turmoil is required for it to do so.”
Mario Draghi, the new president of the European Central Bank, which is based here in Frankfurt, has insisted that countries must help themselves by cutting spending and taking steps to make their economies more competitive.
Jens Weidmann, president of the German Bundesbank and an influential member of the central bank’s governing council, went further Monday, saying it would be illegal to use the central bank to solve government budget problems.
“The increasing demand being placed on monetary policy is dangerous,” Mr. Weidmann told an audience of bankers in Frankfurt. “Monetary policy cannot and may not solve the solvency problems of governments and banks.”
What the markets want to hear, though, is not only prescriptions for long-term overhauls but also assurances that the central bank will do whatever it takes to prevent a near-term panic.
Italy, unlike Greece, is solvent, in that it has the economic resources to manage its debts. That is why many economists say it makes sense to protect Italy from a temporary inability to meet its cash-flow obligations. And with marketplace trust being a top component of getting access to money, the reassurance that the central bank stood ready to step in as a lender to governments might be enough to keep the central bank from having to actually take that action.
But as long as worry continues that Italy may not be able to service its debt, Italian bonds are losing value as interbank currency — a big disadvantage for banks in Italy or France that own tens of billions in Italian debt. Last Tuesday, LCH Clearnet, a company that acts as an intermediary in bond and other trading, said it would impose a steeper discount on Italian bonds used as collateral.
As a central bank, the E.C.B. could theoretically use its ability to print money to buy huge amounts of debt from Italy and other countries. That would drive down their borrowing costs and ensure that they could continue to service their debts — that they would remain liquid, in other words.
The central bank’s charter does not allow it to buy bonds directly from national treasuries, as the Federal Reserve has done in the United States as part of its so-called quantitative easing program to ensure liquidity in the lending markets. And yet, the central bank can and does do essentially the same thing, by buying government bonds on the open market.
Since last year, the bank has spent 187 billion euros intervening in bond markets. But the relatively modest sums, less than 10 percent of the central bank’s total balance sheet, have not been enough to prevent yields on Italian bonds from rising.
If the interest rates that Italy must pay to borrow remain at their current levels, the government could eventually go bankrupt.
The only limit to the central bank’s ability to create money is a psychological one — the fear of setting off too much inflation. Mainstream economists, though, do not see any risk of significant inflation under current circumstances. The euro area is headed for recession, unemployment is rising and factories are not producing as much as they could. That is why economists tend to encourage the bank to put more money into circulation.
Mr. Draghi seems to be in agreement on at least the point that inflation is not a big threat right now, which is why his first act as the bank’s president was to announce a cut in short-term interest rates.
But if the central bank were to step up its bond buying, it would continue to encounter the shrill opposition of Germany, which has a fear of inflation steeped in history. And Berlin’s voice on such matters is hard for Mr. Draghi to ignore, as German financial support is essential to the survival of the euro area.
Mr. Weidmann of the Bundesbank, expressing a widely held view in Germany, warned Monday that if the central bank were used to bail out nations, “nothing less is at stake than the credibility of monetary policy.”
For many economists, though, the bigger worry is how credible any monetary policy would be if it failed to stave off an Italy Moment.