By Johanna Treeck

FRANKFURT (MNI) – European Central Bank President Mario Draghi will
face a massive communication challenge on Thursday, as the central bank
is unlikely to follow through with radical new measures markets thought
they had been promised.

While some caution has seeped into hopes for immediate action
following Draghi’s promise that the ECB will do “whatever it takes”,
complete inaction on Thursday could rattle markets.

At the very least, Draghi will have to keep up verbal intervention
and for credibility’s sake shed some light on his preferred course
ahead. At the same time, he will have to carefully avoid raising
expectations on which he may not be able to deliver.

While leaks following Draghi’s speech suggest that Europe is
working behind the scenes on a big coup to rein in the crisis, they made
equally clear that disagreements remain as strong as ever, not only
among governments but also within the ECB Governing Council.

One option under discussion would see the European bailout fund
EFSF buy Spanish and possibly Italian debt in the primary market in
tandem with ECB intervention in the secondary market to ensure the
transmission of its monetary policy. The ECB may drop its senior
creditor status for bonds its purchases under a new program for maximum
effectiveness.

To kick-start the process, Spain would have to request the EFSF to
start buying its bonds. But fearing conditionality, Spain reiterated
Tuesday that it had no intention of asking for aid. Unless one side
budges on the conditions, a deal by Thursday appears unlikely.

Another option under discussion is boosting the firepower of the
permanent bailout fund ESM by granting it access to ECB refinancing
operations. But this option would appear both more difficult to
implement and less effective.

According to legal opinion of the ECB from March 2011, it would be
illegal for the ESM to access ECB funds. Draghi affirmed this view only
a few short weeks ago. A U-turn on this position would pose a massive
credibility risk.

Even if the ESM and governments can agree to drop the senior status
of the fund, its effectiveness could be undermined by its voting rules
that give France and Germany the ability to block any aid unilaterally.
The permanent question marks over the extent of political commitment
could well undermine the fund’s impact.

Whether or not a counterparty deal will be reached, it will almost
certainly not come before the German Constitutional Court has approved
the fund, which will only happen on September 12, not even in time for
the ECB’s policy meeting next month.

The ECB could of course simply reactivate the SMP. But the lessons
from previous intervention in Italy without conditionality showed that
this merely served to dampen reforms efforts. What is more, the ECB’s
decision to assume senior creditor status for bonds bought under the SMP
may have turned it into a destabilizing rather than a stabilizing
factor. The Council’s appetite to re-activate the program unilaterally
appears slim.

The Bundesbank has made clear that it “has not changed its views on
ECB bond market interventions.” Similarly, German Finance Minister
Wolfgang Schaeuble poured cold water on coordinated ECB/EFSF debt buying
in the near term, asserting that “there is nothing to these
speculations” and that Spain can deal with current yield levels. The
German government said there are no secret talks on giving the ESM a
banking license and that it sees no need to do so.

With the debate still very much in flux, Draghi will find it hard
to offer the guidance to convince markets that Europe is gearing up for
intervention without raising premature expectations.

Key questions Draghi will face for guidance will likely include
whether he is ready to affirm his opposition to granting the ESM access
to the ECB’s liquidity? Would the ECB insist on its senior creditor
status for bonds purchased under any possible new program? What role
does conditionality play for future action?

Some observers argue that Draghi may push for a rate cut on
Thursday to deliver at least on one front and bridge the time until
Eurozone officials may have brokered a bigger deal to rein in the
crisis.

But as ECB policy-makers continue to mull the option of a deposit
rate in negative territory, on this front too there may be more talk –
possibly signalling a rate cut for September – than action. Executive
Board member Benoit Coeure and Governing Council member Ewald Nowotny
both said that the next move will require careful consideration and that
technical details had not been worked out.

Another area in which the ECB may act in the months ahead is its
collateral framework in a bid to ensure that banks in the periphery
continue to have access to liquidity. The ECB could start accepting a
broader range of collateral, such as equities or bonds not issued in the
Eurozone. It could also once again lower its reserve requirements.

While widening the collateral framework is an ongoing discussion,
Draghi cautioned last month that “this is not something we can come out
with soon because it is highly complicated.” This suggests new rules
will not be ready this Thursday.

The ECB could also ease conditions for banks in the periphery by
embarking on credit easing via bank debt purchases. This could include
buying more covered bonds, but senior and unsecured debt aimed at fixing
the monetary transmission mechanism may also be an option.

Overall, this Thursday may see more talk than action. Even if
recent verbal intervention by Eurozone policy-makers has turned the tide
temporarily, markets will not stay calm for long if action does not
follow. It will take more than words to end the crisis and the ECB will
no doubt soon have to prove that it is ready to “whatever it takes.”

Bundesbank opposition or not, Draghi has made clear he is willing
to go all the way to keep the Eurozone together and he will likely find
a majority on the Governing Council. Should governments fail to broker
an effective deal in the months ahead and the debt crisis continue to
undermine confidence and economic activity, the ECB may still act
independently, embarking on QE in the face of downside price pressure.

–Frankfurt newsroom +49 69 72 01 42; Email: jtreeck@marketnews.com

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