THE EUROPEAN Central Bank is under growing pressure to take fresh action to stem a widening crisis of confidence in euro zone government debt, though it remains likely for now to stop short of buying bonds.

Markets punished the euro and bonds on the weak periphery of the zone after ECB president Jean-Claude Trichet said central bankers did not even discuss at its Thursday meeting what analysts have dubbed “the nuclear option”. Market conditions may not so far be bad enough to convince the ECB to take that controversial step.

Instead, the ECB’s next steps could include reinstating 12-month loans for banks at fixed interest rates, lending US dollars again, or announcing a blanket waiver of its collateral rules for all euro zone sovereign debt in money market operations.

“Market expectations certainly are that the ECB will do something, that the governments would take too long to do something or they are not willing, not able,” said Fortis economist Nick Kounis. “Therefore the ECB, which has more flexibility, should jump into that vacuum.”

The difficulty which euro zone governments had in negotiating their €110 billion bailout of Greece suggests they cannot be counted upon to agree on fast, concerted action to prevent credit jitters from spreading through global markets. That may leave the ECB as the only European institution with the ability to intervene effectively in the widening crisis.

Mr Trichet will meet other top central bankers at the Bank for International Settlements (BIS) in Basel this weekend, an excellent opportunity to discuss any co-ordinated liquidity action.

There is a precedent: central bankers from Europe and North America agreed in principle on joint liquidity injections at the November 2007 BIS meeting, and actually conducted those injections a month later.

European central banks have let currency swap lines with the US Federal Reserve lapse, but these could be restarted at any time.

The ECB held a conference call with commercial banks yesterday to gauge the state of money markets.

“It is a possibility for the US Fed and the ECB to do this specific market measure in just a few hours because it is just reinstalling something that was there before,” said one money market desk head who participated in the call.

Economists said the ECB would likely hold the option of buying bonds in reserve until it had exhausted more conventional ways of flooding markets with cash.

“They are most likely to do if there is a further panic on the market and we see a further increase in the LIBOR/OIS spreads and interbank confidence for lending does subside – then I think the ECB will be the only institution that will try and calm markets down,” said Kenneth Broux from Lloyds TSB.

Many say that anything short of government bond purchases may fail to calm the markets.

EU rules prohibit the ECB from buying government bonds from the primary market, but this would not be a show-stopper.

“You have this ‘no monetary financing’, but you are allowed to buy in the secondary market, so what’s the difference?” an official involved in European banking supervision told Reuters. “Buying in the secondary market, you take the pressure, and so you push people in the primary market.”

Analysts have estimated the ECB might buy some €200 to €300 billion of bonds, about 20 to 30 per cent of estimated annual new issuance in the euro zone.

Its covered bond programme was comparatively larger, comprising about 60 per cent of new issues at the time. But some analysts say the ECB would sacrifice credibility as an inflation fighter if it bought government bonds, potentially affecting inflation expectations.

This probably explains Mr Trichet’s uncompromising tone on Thursday. – (Reuters)