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ECB’s bond buying pledge gets Spain, Italy borrowing costs down

Some fear the Bank could end bond buying too soon, leading rates to rise again.

A risky European Central Bank (ECB) decision to fight the continent’s debt crisis by buying Spanish and Italian bonds on Monday started pushing down the soaring interest rates threatening those countries with financial disaster.

But some analysts cautioned that buying up the bonds of deeply indebted governments transfers significant risk to the balance sheet of an institution long reluctant to move beyond its traditional role controlling inflation.

Others expressed fears that the ECB could end its bond buying too soon, leading rates to rise again. Bond yields and prices move in opposite directions; purchases that drive up the price also reduces the interest rate countries face on new bonds.

The ECB has been reluctant to become directly involved in Europe’s 21-month-old financial crisis, instead pushing politicians to get their countries’ finances under control and give the region’s euro440 billion rescue fund the power to buy government bonds on the open markets.

But a recent spike in investor concern about Italy and Spain’s high debt levels and lacklustre economic growth caught the 17-country eurozone just as parliaments broke up for the summer recess, delaying the crucial changes to the bailout fund known as the European Financial Stability Facility (EFSF).

Most governments say they won’t be able to approve the expansion of the fund before September.

“For a democratic process with such heavy stakes, we cannot go any faster,” French Finance Minister Francois Baroin said on Europe-1 radio.

Left as the last line of defence, the ECB said late Sunday that it had decided to “actively implement” its bond-buying program, a crisis tool it had not yet used for Italy and Spain.

The radical expansion of the ECB’s bond-buying program to the eurozone’s third and fourth largest economies cements the bank’s unwilling role as the institution with primary responsibility for solving the region’s crisis.

But some economists said the risk of Spanish and Italian default could soon return if the ECB hands off bond-buying to the EFSF, whose resources are fixed by eurozone leaders while the bank’s are, in theory, unlimited.

Analysts at the Royal Bank of Scotland said they expected the central bank to buy an average of euro2.5 billion worth of Spanish and Italian bonds each day, equivalent to euro600 billion a year. Eventually, the bank could wind up purchasing euro850 billion (US$1.2 trillion) of Spanish and Italian debt, the analysts added.

“You need somebody who is known to have unlimited firepower, and that’s what the ECB has,” said Paul De Grauwe, an economist at the Catholic University of Leuven. “There is no limit to the amount that the ECB can intervene. And once people see the central bank is ready to do this, they won’t need to do it. It’s an insurance mechanism.”

Economists say the euro440 billion fund is too small to rescue Italy if that becomes necessary, and its ability to support Italian and Spanish bonds maybe limited when it receives those powers later this year.

Germany Finance Ministry Christoph Steegmans said however, that Germany remains opposed to increasing the size of the fund, and it “will remain what it is.”

Economist Michael Schubert at Commerzbank said he thought that the central bank would make bond purchases only until the EFSF was ready. He said the bank not only risked losses on the bonds, but its reputation as an inflation-fighting monetary authority.

“If people do not believe or are convinced that the ECB is only responsible for monetary policy, but is in effect supporting governments, then this could be a severe loss in reputation and the consequences would be that inflation expectations would go up.”

Another analyst said the program falls short of contentious, long-term solutions such as issuing a joint eurobond, whereby the eurozone as a whole would borrow money in the markets. The problem for Germany is that it would pay higher interest rates under such a scheme.

A more drastic, and controversial, step would be joint control over budgets.

“Small steps have been taken that may put off the future of the euro crisis for a couple of months but it seems to me we have the same issues to contend with,” said Simon Derrick, an analyst at The Bank of New York Mellon. “This is only over once they make the leap to fiscal union or someone leaves and the eurobond is a very strong step towards full fiscal union.”

By the close, the yield, or interest rate, on Italy’s 10-year bonds had dropped 0.7 percentage point to 5.3 per cent while the equivalent rate on Spain’s tumbled 0.9 percentage point to 5.14 per cent.

Italy’s and Spain’s borrowing costs rose to above 6% last week – rates that would seriously strain the finances of the two countries. The goal is to prevent them from an interest rate spiral like the ones that forced Ireland, Greece and Portugal to seek bailout loans from the eurozone and the International Monetary Fund.

Until now, the ECB had invested just under euro80 billion ($113 billion) in Greek, Irish and Portuguese bonds.

In contrast to the bond-buying programs of the US Federal Reserve and the Bank of England, the ECB “sterilizes” its bond purchases by withdrawing funds from the financial system so that the overall amount of money in circulation remains the same, warding off any inflationary effects.

The ECB’s decision to take a more active role came after both Italy and Spain announced new measures to cut spending and boost growth. Italian Prime Minister Silvio Berlusconi on Friday night said that his country would work to balance its budget by 2013, a year earlier than planned.

Spanish Finance Minister Elena Salgado on Sunday announced new reforms aimed at bringing in an extra euro5 billion to help achieve its goal of cutting its deficit to 6% of GDP this year.

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