Last week after Spain’s 10 year borrowing costs skyrocketed to a record and unsustainable level at 7.75% European Central Bank President Mario Draghi boldly proclaimed that the ECB will do “whatever it takes” to preserve the euro followed by a prediction, “And believe me, it will be enough.”
Draghi’s confident pledge was warmly embraced by global markets.
With renewed confidence in Draghi’s pledge which suggests at some level that the ECB would intervene in the bond markets to ease borrowing costs for Spain and Italy while shoring up the banking industry, economists have begun to speculate about the next steps the president of the ECB might take at the ECB meeting on Thursday to signal that the ECB is ready to to prevent Spain from needing a full scale sovereign bailout after receiving a new bank bailout from Europe’s rescue fund, the ESFS.
After Draghi’s pledge late last week the closely watched 10 year bond yields for Spain and Italy dropped to more sustainable levels.
Currently, Spain’s 10 yr. yield is 6.647%
Germany’s powerful central bank, Bundesbank, has already voiced its opposition to additional bond buying under the ECB’s controversial Securities Market Program or SMP because it blurs the line between monetary and fiscal policy.
This week Draghi held talks with Bundesbank President Jens Weidmann who offered his opinion about the potential of the ECB buying bonds.
“The ECB should be aware that its independence also requires it to respect and not overstep its own mandate” Bundesbank President Jens Weidmann said in an interview with former central bank chief Helmut Schlesinger that was conducted on June 29 and published on the Bundesbank’s website yesterday.
Weidmann said that the German central bank has more influence on ECB policy than many of its euro-area counterparts.
The ECB has already purchased bonds through its Sovereign Markets Programme (SMP), purchasing more than €210 billion euros thus far which had mostly limited impact.
However, the ECB could use the SMP to purchase bonds after Spain makes a formal request to the EFSF and re-commits to implement structural reforms.
The ECB may also decide to allow Europe’s rescue fund (ESFS) to purchase government bonds on the primary market while the ECB purchases on the secondary market.
The ESFS could purchase debt jointly with the ECB, however, the ESFS has limited funds, approximately €200 billion, and the permanent Euro area rescue fund, the ESM, is still not established because of legal delays with Germany’s constitutional court which will extend to mid September at a minimum.
For the ESFS to purchase sovereign debt, the government in question, Spain, must make a formal request, and any financial aid would have conditions attached.
Spanish Treasurer Inigo Fernandez de Mesa said on July 30th that Spain has no intention of making such a request, according to Bloomberg.
Another option for the ECB includes the ECB deciding to participate in a third round of Long Term Refinancing Operation (LTRO) for Euro area banks to purchase more bonds and issue loans.
On 29 February 2012, the ECB held a second 36 month auction, LTRO2, providing euro area banks with €529.5 billion in low-interest loans.
Eight hundred banks participated in LTRO2.
The ECB has directed more than €1 trillion into the Euro area banking system during the two previous LTROs which temporarily drove down sovereign borrowing costs in the bond market.
A final option that the ECB could utilize includes lowering interest rates, which is not as likely to occur since the ECB just cut its main refinancing rate to a record low of 0.75 percent last month.