ECB 'could play bigger role'in crisis

Wed, Jul 18, 2012, 01:00

The ECB could play a bigger role in fighting the euro zone sovereign debt crisis through rate cuts, bond purchases and further liquidity provision, the IMF said today in report on the single currency region.

The IMF also said the ECB, which is legally barred from financing governments, could be given full lender-of-last-resort functions, to help break the vicious circle of highly indebted governments borrowing from banks which in turn become vulnerable due to the risk associated with the bonds.

"The ECB can provide further defences against an escalation of the crisis," the IMF report said.

In a separate review of public finances in the EU, the European Commission said that, despite difficult economic times in the region, the pressure to continue with fiscal consolidation measures will be maintained and member states will continue to close their deficits into 2013.

There is “little scope” for some states to ease fiscal tightening, the report said, due to sizeable deficits.

For the EU as a whole, the deficit is expected to fall to 3.8 per cent of gross domestic product (GDP) this year, before slipping to 3.4 per cent in 2013.

Ireland’s budget deficit was the highest in the euro area at 13 per cent of GDP, the report said. In total, 21 member states are still subject to the Excessive Debt Procedure, although Germany and Bulgaria managed to reduce debt to below the 3 per cent limit in what it said was a “sustainable” manner.

The commission also notes default for Ireland’s local government, or county and city councils, is “possible”, but it would most likely be bailed out by the Government.

In an assessment that essentially put it at odds with the IMF, the report notes while economic growth across the EU was a concern and posed a challenge, plans for consolidation based on spending cuts would be more durable

“The need to restore the credibility in the public finances and the danger posed by large deficits and debts are obvious and even more so now that growth prospects are looking weak again,” the report said.

“However, while weak growth causes larger deficits, the effect of consolidation on growth must also be taken into account. As a country consolidates, in the short-term aggregate demand falls and this has a negative impact on growth before the positive impacts from reduced interest payments and reduced taxation kicks in.”

For its part, the IMF said the ECB could further lower borrowing costs, which are currently at a record low of 0.75 per cent, because the economy was weak and inflation risks small.

The bank could try quantitative easing (QE) with "sizable" sovereign bond purchases, possibly preannounced over a given period of time, the IMF said.

"Buying a representative portfolio of long-term government bonds ‑ for example, defined equitably across the euro area by GDP weights ‑ would also provide a measure of added stability to stressed sovereign markets," the IMF said.

"However, QE would likely also contribute to lower yields in already 'low yield' countries, including Germany," it said.

The ECB could also embark on further sovereign bond purchases of countries that are under market stress ‑ its Securities Market Programme (SMP)."A well-communicated re-activation of SMP purchases would likely carry strong signalling effects which might mitigate the need for very large purchases. The benefits from lower yields would also ease collateral constraints on official and interbank lending facilities," the IMF said.

Another way to ease market tensions was to launch another Long-Term Refinancing Operation (LTRO) ‑ cheap, long-term lending by the ECB to banks that ensures they remain liquid despite the frozen interbank lending market. "This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed, the report said ‑ including a broadened collateral base and/or a lowering of haircuts ‑ to address localised shortages.”

"The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links."

The IMF says a priority for the euro zone is to create a banking union, which would entail a common euro zone bank supervisor, as well as a common deposit guarantee scheme and bank resolution fund.

Euro zone leaders agreed the ECB would play the role of the supervisor, but the IMF suggested the bank should also play a role in the bank deposit guarantee scheme, which, while financed from a levy on banks, should have access to an ECB credit line.

Additional reporting: Reuters