'Little scope' to ease fiscal tightening

THE EUROPEAN Central Bank could play a bigger role in fighting the euro zone sovereign debt crisis through rate cuts, bond purchases and further liquidity provision, the IMF has said.

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 said in a report.

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 would be maintained and member states would continue to close their deficits into 2013.

There is “little scope” for some states to ease fiscal tightening, the EC 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 noted default for Ireland’s local government or county and city councils was “possible”, but they would most likely be bailed out by the Government.

It said the need to restore the credibility in public finances and the danger posed by large deficits and debts were obvious. This was even more so now that growth prospects were looking weak.

“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 kick 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 because inflation risks were small.

The bank could try quantitative easing with “sizable” sovereign bond purchases, possibly pre-announced 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. – (Additional reporting: Reuters)