More turmoil inevitable over the summer as Trichet is not for turning

Trichet is under huge pressure to relax his unwavering resistance to any Greek default

CONCERNED ABOUT rising prices in the euro zone, the European Central Bank has increased interest rates for the second time in three months. If only its problems stopped with inflation.

Divisions are deepening in the euro zone over the response to the Greek debt debacle. With talks on a second bailout mired in dispute over the extent and nature of private creditor involvement in a new package, ECB president Jean-Claude Trichet has come under relentless pressure to pull back from his unwavering resistance to any form of Greek default.

He was in no mood for compromise at his monthly press conference yesterday, defiantly repeating the mantra that flexibility is not an option on this front and defending the novel interventionist policies adopted by the ECB in the face of the debt crisis. “Our message is: no credit event, no selective default, no default.”

In the corridors of Frankfurt’s Eurotower, home of the ECB, such concepts raise the sceptre of a Lehman-like explosion in world markets with contagion following swiftly in its wake.

In Berlin, however, the Merkel administration is once again pushing for a debt-swap plan to extend the maturity of Greek bonds by seven years. Desperate to ensure political passage of a second bailout, Germany still wants a “quantified” private sector contribution

The ECB has already rejected the debt-swap notion on the grounds that it would not be purely voluntary, therefore triggering a default. However, Germany sees new scope to go down that road after an adverse assessment by Standard Poor’s of rival French plan, which was comparatively less severe on private investors.

With the final push for a new Greek deal now put back until September, further turmoil seems inevitable through the hot weeks of summer. At issue is whether officials can develop a voluntary scheme to ensure a significant private creditor contribution without any element of coercion. This is proving exceptionally difficult, leading to a new pall of gloom in Brussels as senior figures question what the eventual result of the crisis will be.

At times the debate has resembled a game of chicken between Berlin and Frankfurt, with the ECB threatening the nuclear option of refusing to accept Greek bonds as collateral for its bank support operations if a default was triggered.

Trichet insists the ECB is not for turning, saying any such manoeuvre would be clearly at odds with the generally accepted “international doctrine” for fighting financial crises. But what precisely does he mean?

“What is not in the global doctrine…is the idea that you are asking as soon as on top of the IMF loan …for restructuring, haircuts, you name it. That is not the international doctrine.

“You cannot eliminate a failure, you cannot eliminate drama, but you cannot presume that it is the normal situation to have some kind of a private sector involvement.”

Such ideas have totemic force within the ECB, and there is no sign of any chink in its armour

It remains the case, however, that the bank has changed tack before in the crisis to waive the minimum credit rating thresholds it applies to Greek and Irish debt in its bank support operations.

It did so again yesterday in respect of Portuguese debt in what Trichet described as an “immediate response” to a surprise junk rating on Lisbon by Moody’s.

In the eyes of some critics the acceptance of anything less than investment-grade paper serves to damage the bank’s credibility. But Trichet issued a stern rebuttal when asked whether such criticism was valid.

“All our non-standard measures were taken without any exception to help restore [a] more normal functioning of our monetary policy transmission mechanism. Yes, we are credible sir, very credible,” he added.

“A central bank which delivers over 12 years less than 2 per cent [inflation]\, which was better than what was done by any big central bank in Europe over the last 50 years, has no lecture on credibility to receive. That’s my understanding.”

Trichet retires in October and will make way for Mario Draghi, governor of the Bank of Italy. He is not going quietly. Quite the opposite. The battles continue.