By Jack Duffy

PARIS (MNI) – Investors’ growing nervousness about Italy and Spain
has exposed the limits of how much the European Central Bank’s long-term
financing operations can help the Eurozone.

Of the E1 trillion of liquidity pumped into the system by the ECB’s
two LTROs, fully half has gone to Italian and Spanish banks, according
to analysts’ interpretation of central bank data. Net borrowing from all
ECB refinancing operations in March was a record E227.6 billion for
Spanish banks and a record E270 billion for Italian banks.

But even with bank liquidity cheap and plentiful, stock prices have
skidded and interest rates have climbed in both markets as risk-averse
investors have pulled out. Spain’s IBEX-35 stock index is down 14.7% for
the year, while yields on 10-year Spanish bonds have climbed to 6.09%
from a low of 4.83% in February. Italy’s 10-year bond yields have risen
to 5.63% from 4.81% on March 8, while the country’s benchmark FTSE MIB
stock index is down 4.8% on the year.

With regard to Spain, “funding liquidity is one thing, solvency is
another,” said Martin van Vliet, senior Eurozone economist at ING Group
in Amsterdam. The ECB loans have “done little to fundamentally improve
the solvency situation of either the banking sector or the sovereign,
which is where recent investor concern has centered.”

The ECB would argue that the objective of the LTROs was to prevent
a credit crunch and to help markets return to functioning normally, and
in that they have succeeded. The rest, they might say, is up to national
authorities.

But even the ECB might admit that the LTROs have had the negative
effect of linking the fortunes of fragile banks ever more tightly with
overburdened sovereigns.

In the three months through February, Spanish banks increased their
government bond holdings by a massive E68 billion, while Italian banks
raised their sovereign holdings by E54 billion.

Spanish banks, flush with ECB cash, helped their sovereign achieve
47% of its annual funding target in only three months. Now, however,
with foreign investors pulling back, buying by Spanish banks may also be
slowing, making it harder for the government to fill the gap. And the
banks are increasingly seen by investors as being completely at the
mercy of ECB funding.

If rising market turmoil triggers margin calls by the ECB on
peripheral bonds it is holding as collateral, the pressure will only
increase. Many analysts say it is increasingly likely that the ECB will
have to reactivate its SMP bond buying program to try and stabilize
markets before margin calls become necessary.

Spain could also request assistance from the European Financial
Stability Facility to recapitalize its banks. The EFSF has E240 billion
of unallocated funds that could be tapped.

Another option, which ECB council members play down consistently,
is a third LTRO. With bank lending stagnant, however, there is
widespread doubt that it would have any positive effect on growth.

And despite ECB assurances that there is no stigma attached to
taking LTRO funds, such a stigma has in fact already materialized.
Investors see massive ECB liquidity support for Italian and Spanish
banks as a flashing neon sign that says “Stay Away.”

So as the Eurozone debt crisis faces another potentially long hot
summer, the ECB may have to return to the sort of fire-fighting many
Governing Council members had hoped was finished, while it waits for
Eurozone policymakers to figure out their next move.

(EuroView is an occasional column written by Market News
International editorial staff. Any views expressed are solely those of
the writer)

–Paris newsroom, +33142715540; jduffy@marketnews.com

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