ECB's Draghi faces leadership test over euro pledge

FRANKFURT (Reuters) - European Central Bank President Mario Draghi was under intense pressure from investors, European leaders and even the United States to deliver on Thursday on his pledge to do whatever it takes to save the euro.

Draghi faced the biggest test of his nine months' leadership of the central bank at its monthly policy meeting, which began at 0700 GMT. Any sign that he overplayed his hand when he made the bold pledge a week ago could see markets punish the euro zone.

"Draghi has unfortunately painted himself into a corner," JP Morgan analyst Pavan Wadhwa said in a conference call. "The ECB does need to demonstrate its credibility... Otherwise Draghi will lose face completely."

Reuters reported on Monday that the main idea under consideration is re-activating the ECB's bond-buying programme for Spain and Italy in tandem with the euro zone's rescue funds, but that action could be at least five weeks away.

Finnish Prime Minister Jyrki Katainen told an Italian newspaper European leaders were preparing for the euro zone's rescue funds to buy bonds on primary market for two years, with a decision likely in September.

German daily Sueddeutsche Zeitung reported the ECB was planning concerted action with the European Stability Mechanism (ESM) to purchase sovereign debt from Spain or Italy - though a final decision was not likely until September.

The ECB has little margin for error to maintain its credibility and avoid bond yields climbing to unsustainable levels in the indebted countries on the euro zone periphery.

Katainen told Italian newspaper La Stampa: "We will make our proposal in September. So far what has been discussed has been using the ESM to buy bonds of countries in trouble on the secondary market, but I don't think that's the right solution.

"Last year the ECB did that and calmed the markets for a few weeks and then everything went back to how it was before."

He told another Italian newspaper, Repubblica: "We have to find the way to use the (ESM) more efficiently, for example by buying state bonds on the primary market. That would go straight at the problem, lowering spreads more strongly".

Market faith in the euro zone's crisis management efforts will be tested by a bond auction that could see Spain's borrowing costs rise further before the ECB's 1230 GMT post-meeting news conference.

Draghi said last Thursday that the political capital invested in the euro is often underestimated.

"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," Draghi told an investment conference in London.

Spanish and Italian bond yields fell markedly after Draghi's speech, and inaction could send them higher again.

"We could see markets going back to where they were before last Thursday," said Nordea analyst Anders Svendsen, who expects more words but little concrete action from the meeting.

Other countries, especially the United States, have sought to raise pressure on the ECB to act. U.S. Treasury Secretary Timothy Geithner said the euro zone must take steps to bring down borrowing costs in troubled member states.

GERMAN DISSENT

The ECB has already bought government bonds through its Securities Markets Programme (SMP), spending more than 210 billion euros on them so far. Re-employing the existing tool would avoid legal battles that any novel measures could face.

While the SMP is widely viewed as having had very limited success, it is at least available immediately and could be used in a new form, combining it with the euro zone's temporary EFSF and permanent ESM bailout funds.

The ECB could use the SMP to buy bonds once Spain makes a formal request for assistance and signs up to a reform programme with international monitoring.

A revival of ECB bond purchases was seen as the most likely option in a Reuters poll of money-market traders.

"Based on Draghi's comments a restart of SMP (or EFSF/ESM) buying appears the most likely response," Danske Bank's Allan von Mehren and Anders Moller Lumholtz said in a note.

Another option for a quick start, suggested by Goldman Sachs economist and former senior ECB official Huw Pill, would be for the ECB to let national central banks buy private-sector assets in targeted operations to ease credit availability.

ECB action is hamstrung by EU rules forbidding it from financing governments. The ECB issued a legal opinion in March 2011 ruling out perhaps the biggest gun, giving the ESM bailout fund rights to tap the ECB for funds to increase its firepower.

Draghi himself has argued against the move, but last week Governing Council member Ewald Nowotny broke ranks and said it could be advantageous to give the ESM a banking license that would allow it to borrow. Some ECB watchers believe his call was a trial balloon sent up in coordination with the ECB leadership.

The ECB has to find a way to get any measures past Germany, the euro zone's largest economy and its principal paymaster. The Bundesbank issues regular reminders of inflationary dangers stemming from non-standard measures such as bond purchases and the limits central banks face.

On Wednesday, the German central bank released an interview in which Bundesbank President Jens Weidmann said: "Politicians overestimate the central bank's capacity and place too many demands of it."

The dilemma for Europe is that too little action now could create bigger problems later. If borrowing costs don't come down, forcing both Spain and Italy to seek aid, the ESM's 500 billion euro capacity would soon be exhausted, and it would need more funds.

NO RATE CUT EXPECTED

Another tool at the ECB's disposal - cutting interest rates - is unlikely to be used again so soon after it lowered the main refinancing rate to a record low of 0.75 percent in July. A Reuters poll showed that economists expect another rate cut before the end of the year, but only seven out of 70 expected it this month.

As the crisis has intensified, the euro has weakened in foreign exchange markets. It has fallen about 15 percent in the past year to trade at $1.23. On a trade-weighed basis it trades at nine-year lows.

The falling euro is good for European exports but is likely to delay the day when inflation falls below the ECB's target of 2 percent. In July, it remained at 2.4 percent. It also assuages fears of deflation, a spectre that could otherwise have prompted the ECB to consider large-scale bond buying.

"To move into large-scale asset purchases from purely monetary stance motivation will take a while," J.P. Morgan economist David Mackie said. "It's certainly not going to happen ... until we get into next year."

(Reporting by Sakari Suoninen; Editing by Will Waterman and Paul Taylor)

Source: http://news.yahoo.com/ecbs-draghi-faces-leadership-test-over-euro-pledge-075157002--business.html

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