The threat posed by contagion in the euro zone’s debt crisis is far from over

THE INTERVENTION of the European Central Bank this week to buy Italian and Spanish bonds has successfully dragged the two countries’ cost of borrowing to sustainable levels. However the threat posed by contagion in the euro zone’s debt crisis is far from over, with analysts warning yields could rise again to danger levels (generally understood to be 6 per cent rates on 10-year bonds) if the ECB does not continue to buy the debt of both states in the short run before a longer-term solution is agreed.

The ongoing turmoil in global stock markets and weakening economic sentiment in Germany and the US while European politicians remain on their holidays is adding to existing concerns that the ECB’s current “sticking plaster solution” may not work.

“It still remains to be seen how credible the ECB is this time round and how sustained they are in terms of their purchases, and we wouldn’t exclude for the whole thing to turn around again,” WestLB rate strategist Michael Leister warned yesterday.

Q Why can’t the ECB simply continue to buy Italian and Spanish bonds?

AThe ECB is the EU institution which administers the monetary policy of the euro zone and its core mandate is to maintain price stability, in other words to keep inflation low. It does not have a mandate to intervene in the fiscal affairs of euro zone member states, a political role that is the reserved for the European Commission.

Critics argue that intervening to buy the bonds of financially distressed euro zone states is a political act that undermines the bank’s credibility and independence. Germany is particularly concerned its taxpayers could end up footing the bill if Italy and Spain default on their debts.

ECB president Jean-Claude Trichet has already made clear he is deeply uncomfortable with the bank taking on the responsibility of lender of last resort, a role he believes is the responsibility of euro zone member states under the EU treaties.

In an interview yesterday on French radio, Mr Trichet defended the ECB’s intervention on the bond market to meet Europe’s “worst crisis since World War II” but he also signalled clearly that it was not the ECB’s main job to tackle the debt crisis.

“What we expect is that the euro zone governments do what we consider to be their job,” said Mr Trichet, who refused to say how long the central bank would continue to buy bonds.

There has already been opposition within the board of the ECB to its decision to buy Italian and Spanish bonds. Last week, Jens Weidmann, the recently appointed Bundesbank head, opposed, initially at least, a decision to buy these bonds.

It has emerged that the ECB only began buying Italian and Spanish bonds on Monday when both countries agreed to fast- track reforms and cut their debt levels, following demands made in a letter sent last Friday by Mr Trichet.

Q Is the European Financial Stability Facility (EFSF) the solution?

AAt an emergency summit on July 21st, euro zone states agreed reforms to strengthen the powers of the EFSF, a €440 million rescue fund created to tackle the debt crisis. The fund can counter movements in the bond markets by buying bonds in the secondary market to prevent any further bailouts and by forcing private investors in Greek debt to get involved in the bailout through a mechanism known as private sector involvement.

However, the deal has not yet been implemented as it requires technical work to be completed to determine the exact scope of the powers.

The parliaments of member states must also ratify the agreement, which is not likely to happen until the end of September. This has left the ECB with the job of supporting Italy and Spain.

There are also mounting concerns that the €440 million fund simply does not have the firepower to protect Spain and Italy, the latter of which has some €1.9 trillion in public debt, equivalent to 120 per cent of gross domestic product.

In a move widely criticised by Germany, European Commission president José Manuel Barroso suggested as much by calling for a “rapid reassessment” of all elements of the stability fund to address market concerns over Italy and Spain.

Daniel Gros, director of the Centre for European Policy Studies, said Berlin’s opposition to enlarging the fund stemmed from the political difficulty in German chancellor Angela Merkel asking for more money prior to ratification in the German parliament. He warned that the fund would need to be expanded and refinanced via the ECB.

Q What about creating euro bonds?

AThe idea of issuing debt centrally by the euro zone on behalf of struggling governments has been around for a long time. By spreading the risk for investors across all euro zone states – including AAA-rated states such as Germany and the Netherlands – weaker countries could borrow at significantly lower interest rates.

Minister for Finance Michael Noonan and Tánaiste Eamon Gilmore have both floated the idea on recent trips to Brussels, arguing it would allow Ireland to re-enter the markets to raise debt.

A variant could see the EU offer guarantees on bond issues by individual euro zone states. This proposal is opposed by Germany and some other AAA-rated euro zone states, which, by guaranteeing weaker states’ bonds, would end up paying more to raise their own debt.

There is also a fear that some states, such as France, could lose their triple AAA status.

EU analysts suggest introducing euro bonds would also be legally tricky as it would involve changes to the EU treaties. Issuing debt centrally would also involve a major step towards a closer fiscal union, which is hugely politically sensitive.

Q How far is Germany prepared to go to solve the debt crisis and save the euro?

ABerlin, which has traditionally been the paymaster of the European Union, insists it is determined to save the euro but an increasingly sceptical German public does not want to bail out profligate member states that refuse to implement reforms.

Dr Merkel faces pressure from her own coalition partners, the Free Democrats, and her own party against calls for more expansive measures to tackle the crisis. Her room for manoeuvre is increasingly limited due to falling approval ratings.

Some EU officials though say Germany has changed its position several times since the crisis began and has grudgingly put up money to avert a catastrophic collapse. It is sure to be tested by the markets in the weeks ahead.

Q What is the price for receiving EU backing?

AGreece, Ireland and Portugal have already signed up to onerous reform plans through their EU-IMF programmes. Italy and Spain have also promised further reforms following ECB intervention to lower their cost of borrowing. However plans are already afoot in Berlin to introduce more onerous oversight and penalties for euro members.

German economy minister Philipp Roesler has proposed a euro area “stability council” to oversee efforts by ailing states to cut debt and boost competitiveness, a move he said would help calm markets in the longer term.

This council would be part of an overhauled stability pact, which required countries to adopt constitutional debt controls and undergo a “competitiveness check”. It would also be able to impose automatic sanctions on states that fail the test.