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Wednesday, Sep 5, 2012 12:00 PM UTC

All eyes on Draghi’s bond rescue plan for Europe

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Topics: From the Wires,

FRANKFURT, Germany (AP) — European Central bank President Mario Draghi gets another chance Thursday to spell out how the bank intends to rescue the 17 countries that use the euro from financial disaster.

Expectations have been high since late July when the ECB head vowed to do “whatever it takes” to hold the eurozone together. The following week, on Aug. 2, Draghi announced the broad outlines of a plan to buy government bonds to help out eurozone countries struggling to manage their debt.

Until then, countries such as Spain and Italy had seen their borrowing costs — reflected in the interest rates on bonds they sell — rise to unmanageable levels. Investors were worried the two countries could soon get to a point where they couldn’t afford to handle their finances and be pushed into asking for a bailout.

That has already happened three times in the eurozone — with Greece, Ireland and Portugal. The worry is that Spain and Italy are too big to bail out. If those countries fail to pay their debts on time, it could spark a financial crisis that could see the eurozone break up, spreading turmoil throughout the global economy.

Analysts say Draghi’s comments Thursday are likely to be constrained by the fact that the ECB is still working on its plans. The ECB chief has to strike a delicate balance: promise and reveal enough to keep markets happy, while nudging Europe’s politicians to do more.

Here is a look at what Draghi and the ECB have been working on and what to look out for on Thursday:

—BOND-BUYING STRATEGIES:

By buying bonds on the open market, the ECB can drive up the prices for a country’s bonds. That brings down their interest rate — or yield — and makes it less expensive for countries to borrow money. The ECB theoretically has no limit on the money it can use for its bond-buying plan. As a central bank, it can “print money” to pay for the bonds by simply adding to banks’ reserve accounts.

How much it spends on bonds sends a message to the markets. Too much and it could be criticized for violating the EU treaty provision that forbids it from financing governments directly. Too little and investors think that ECB is only half-heartedly attempting to solve the eurozone’s problems. A previous bond-buying program started in May 2010 piled up over €210 billion ($264.16 billion) but was too limited to decisively lower yields.

One option for the ECB is to set an interest rate ceiling — once a country’s yields hit a certain point, it would step in and buy the bonds. However, while such a strategy would show the ECB has a level at which it would intervene, it would also tie its hands, forcing it to defend that red line or lose credibility.

The mere announcement last month that the ECB might intervene has already sent the yields down for Spain and Italy. Spain’s yield on its 10-year bonds, for example, has fallen from a high of 7.54 per cent in July to 6.51 per cent this week. This is a move in the right direction but still much higher than the more financially secure eurozone countries, such as Germany which has a 1.4 per cent yield.

Anticipation grew even more intense when Draghi skipped a key central bank conference in Jackson Hole, Wyoming, because of the workload ahead of Thursday’s meeting.

—POTENTIAL PITFALLS:

Draghi has to tread a fine line — not only does he have to keep the markets from panicking and pushing bond yields even higher, but he also has to play a political game. First he has to make sure that the ECB’s 23-member governing council is on his side. This might not be easy when Germany’s central Bundesbank — an influential member of the council because of the size of Germany’s financial commitment to the eurozone — has so far been critical of the bond purchase plans. Its head, Jens Weidmann, has warned that governments could become addicted to the help and avoid making unpopular spending cuts and tax increases to get their debts under control.

Draghi will also have to keep governments in line if the bond-buying program is to succeed. When he announced his plan last month, Draghi stressed that governments who want help must sign up for a to-do list of conditions. But once the ECB has stepped in, will countries stick to their commitments after the pressure has been taken off their finances? The history of the eurozone crisis is littered with broken promises and missed targets.

One weapon in the ECB’s arsenal could be halting the bond purchases, turning up the heat by letting borrowing costs rise again. This is a risky option. It would send a strong message to the countries being helped out but it could reignite market panic and send yields spiraling.

Economists have suggested Draghi may push for a tough version of enforcement. That could involve bringing in the International Monetary Fund to monitor a government’s progress.

“Everyone loves a generous central banker… There’s a tight balancing act here, in which the ECB should provide a safety net, but not give too much away for free,” wrote Rabobank analyst Jan Lambregts in a note to investors.

—WHAT TO EXPECT THURSDAY:

The only thing that’s certain about Thursday is that analysts and politicians will pore over every word uttered by Draghi.

Rather than giving detailed plans about how the ECB is ready to start bond-buying Thursday, Draghi is more likely to lay down the law. Politicians will probably be given another stern warning that they’ll have to abide by strict conditions if they want help. The pressure will be put back on leaders such as Spain’s Rajoy and Italy’s Premier Mario Monti to act first. Only once governments have applied to the eurozone’s emergency bailout funds for help, will the ECB get going with its bond buying.

While the focus of attention will be on what the ECB president will — and will not — say about the bank’s bond-buying program, the ECB could also use another measure to help strengthen the eurozone’s finances — interest rates. Economists are divided on whether a quarter-point cut in the ECB’s benchmark interest rate to a new record low of 0.5 percent might be on the cards.

Analyst Carsten Brzeski at ING said that “not all the detail might be revealed this week, perhaps because there is not yet full agreement within the governing council, but maybe also to keep pressure on” indebted governments in southern Europe.

Jacques Cailloux, chief European economist at Nomura International, said he expects Draghi to give “almost no detail” on Thursday. Instead Draghi will assure markets that the ECB “stands ready to intervene and to reiterate that this will only come when the call for help has been made.”

Draghi’s remarks will be “with a view of keeping maximum flexibility and reflect that they might not be fully prepared just now, and to not get cornered with very specific targets.”

More David Mchugh.

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