European bank sets out plans to tackle euro crisis

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The European Central Bank has unveiled its most ambitious plan yet to halt Europe’s financial crisis with a pledge to buy unlimited amounts of the government bonds of countries struggling to manage their debts.

Large-scale purchases of short-term government bonds would drive up their price and push down their interest rate, or yield, making it less expensive for countries to borrow money.

The new plan goes well beyond the ECB’s earlier, limited bond-purchase programme, which was not big enough to decisively lower borrowing costs.

After the ECB plan – dubbed Outright Monetary Transactions or OMT – was announced, the yields on government bonds across Europe fell and stock markets rallied.

“This is a potential game-changer,” says Jacob Kirkegaard, research fellow at the Peterson Institute for International Economics. “This is the first time the ECB has committed its balance sheet in this way. And the way it is done is politically sustainable in Europe.”

But the ECB’s pledge of support came with a caveat: countries that want the central bank to help with their debts must first seek emergency aid from the bailout funds managed by the 17 countries that use the euro and submit their economic policies to the scrutiny of the International Monetary Fund. That puts enormous pressure on heavily indebted countries such as Spain and Italy, which have been reluctant to seek help.

Christine Lagarde, Managing Director of the IMF, welcomed the ECB plan and said the organisation stood “ready to co-operate”.

Analysts warned that while the ECB plan would provide short-term relief it does not address underlying economic weaknesses, which could persist for years.

Still, investors cheered the move. Spain’s interest rate on three-year bond was down 0.17 percentage points to 3.73 per cent while its 10-year bond was down 0.3 percentage points on the day at 6.12 per cent. Meanwhile Italy’s 10-year rate was down 0.1 percentage points at 5.33 per cent and its rate for three-year bonds was down 0.06 percentage points to 3.02 per cent.

In Europe, Germany’s DAX was up 2.7 per cent at 7,153 while the CAC-40 in France surged 2.7 per cent to 3,497. The FTSE 100 index of leading British shares was 1.6 per cent higher at 5,750.

The possibility of ECB intervention impresses markets because, in theory, the central bank has unlimited funds at its disposal.

As the issuer of the euro currency, it can simply create new money to buy the bonds from banks. The eurozone’s bailout funds could buy bonds as well, but they have concrete limits on their finances set by governments that are putting up taxpayer money – and much of that is already committed anyway to bailouts for Greece, Ireland and Portugal.

Still, rescuing governments from immediate disaster will only buy the eurozone time to fix its underlying problems. For one, the purchases do not solve the chronic imbalances that plague the currency union, with some countries able to export and grow while others remain uncompetitive.

There were other technical but important details revealed. The ECB agreed to give up preferred creditor status, which could have frightened away other creditors afraid they would take all the losses in case of a default.

It also agreed to ward off any increase in the supply of money in the economy, a side effect of making purchases with newly created money. The bank said it would withdraw an equivalent amount from the financial system, which it can do by taking deposits or selling notes.

Some analysts believed the programme unveiled today would not solve the underlying problems in the eurozone, however. “Without trying to be a ‘party pooper’,” said Neil MacKinnon, global macro strategist at VTB Capital, “suppressed borrowing costs certainly provide relief in the short term but do not resolve problems of solvency and debt unsustainability.”