ECB Withholds 'Nuclear Option'
By TERENCE ROTH and GEOFFREY T. SMITH
FRANKFURT—The European Central Bank's monetary council withheld its strongest weapon for stopping the Greek debt crisis from spreading to weaker euro-zone financial markets, but ECB watchers don't rule out a later deployment.
Called the ECB's "nuclear option" in the markets, the procedure would involve the purchase of government bonds in the secondary market. Rumors that it could be activated as early as Thursday were flatly dismissed.
"We did not discuss this option," ECB President Jean-Claude Trichet said Thursday at a news conference, brushing aside all attempts at elaboration.
European credit markets, shares and the euro all reacted negatively to the news that the ECB was taking no further action to contain the contagion threat. The cost of insuring western European sovereign debt against default using credit default swaps continued to rise after Mr. Trichet's address, with fiscally vulnerable countries Greece, Portugal and Spain particularly affected. The euro, meanwhile, fell to a fresh 14-months low against the dollar of $1.2695, and bank stocks came under pressure.
The ECB again left interest rates unchanged at its policy meeting in Lisbon, but attention in financial markets has been focused on what else the ECB can do to reassure investors and staunch the contagion effect of Greece's turmoil.
The idea of the ECB buying government bonds is deemed the strongest means of putting to rest investor antiestéticars that government bond issuance would no longer find buyers because of perceived default risk. Knowing that the ECB would step in might put a cap on speculation, but it also would be a huge undertaking and would amount to monetizing debt, which no central bank likes to do because it raises inflation risk.
The European Union treaty forbids primary purchases of bonds directly from national treasuries, but leaves room for indirect purchases of securities that have already gone on the market.
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Bond purchases would retard or even reverse the run-up in premiums that fiscally weak governments have to pay on their debt, and also cap the rising price of insuring that debt against default. But analysts say the fallout could be potentially devastating for the 16-nation euro currency and the primary institution behind it, the ECB. For that reason, it is a last-ditch measure that the ECB really hopes to avoid having to use.
"There is probably nothing more frustrating for policy makers [than] to see that the Greek program is already being brushed aside by the market, which is now entirely concentrated on a full-blown contagion across euro-area countries and euro-area asset classes and spilling over to global markets," analysts at the Royal Bank of Scotland wrote in a research note Thursday.
"Our belief that such a radical policy response is not going to be announced imminently (or today, for example) is based on the fact that most policy makers are still focused on the Greek issue as being the source of all the problems," RBS said.
Moody's Investors Service, the ratings agency, echoed that warning in a report issued Thursday, saying that the potential contagion of sovereign risks to banking systems could spread to other countries such as Portugal, Spain, Italy, Ireland and even the U.K., which is outside the euro zone.
Those antiestéticars weighed on sovereign debt markets, with the annual cost of insuring $10 million of five-year Spanish government debt rising to $260,000 after Mr. Trichet spoke, from $230,000 immediately after a successful Spanish bond auction. Greece's insurance costs on $10 million of five-year debt shot up to $875,000 from $815,000. And Portugal's rose to $455,000 from $430,000 beforehand.
CDS ******** like default insurance contracts for debt. If a borrower defaults, the protection buyer is paid compensation by the protection seller.
"Trichet is going for the 'crisis, what crisis? approach," said Gary Jenkins, head of fixed-income research at Evolution Securities. "I am not convinced that this denial of the problems facing European sovereigns is healthy. It is also difficult to believe that they didn't even discuss the possibility of buying government bonds," he said.
At the very least, the trouble in Greece is likely to stop in its tracks the ECB's gradual return to a "normal" monetary policy stance.
"With panic spreading in the market, demand for liquidity is picking up," UniCredit analysts said in a Thursday note to clients.
As talk of a broader crisis with euro-zone sovereign debt spreads, conditions in the market for covered bonds have deteriorated too, raising the possibility that the ECB may have to extend its €60 billion ($76.93 billion) support program to that segment.
Many think the central bank may be forced to start offering unlimited funds for longer periods again, after trying to phase such operations out over the last six months.
This week has seen a big increase in euro-zone banks' use of both the ECB's deposit facility and its marginal lending facility. The first is an indication that they are scared of lending to other banks, the second a sign of their inability to borrow in the market.
The Greek crisis already has forced the ECB to abandon its plan to restore its original, tighter criteria for the debt it accepts as collateral at its lending windows. Its announcement Monday that it would continue to accept Greek bonds indefinitely as collateral, even if the world's rating agencies all considered them junk, averted a systemic crisis among Greek banks. But it amounted to a humiliating U-turn for Mr. Trichet, denting the authority of the bank as a whole.
Write to Terence Roth at
terence.roth@dowjones.com and Geoffrey T. Smith at
geoffrey.smith@dowjones.com
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