PARIS (MNI) – The Governing Council of the European Central Bank is
still undecided about how quickly to withdraw emergency liquidity
measures and what — if anything — it should do to discourage certain
banks from being too reliant on ECB funding, well-informed monetary
sources told Market News International.

There is a clear split on the Council over these issues.

Some members want to make substantial new exit moves early in the
new year and implement measures — perhaps relating to haircuts on
collateral — aimed at limiting the ability of some banks, largely in
the peripheral Eurozone countries, to borrow in such high volumes from
the ECB, these sources said.

This group of Council members frets about the moral hazard and
inflation risks of accommodating banks with cheap liquidity for too
long. They also believe that if they do not decide on the next exit
steps relatively quickly and communicate them clearly to the market,
they risk sending an unsettling message that things are bad out there.

Some members are even pushing for a decision to be taken and
announced as early as this Thursday, according to one senior Eurosystem
official — though such an outcome seems highly unlikely given the
disagreement on the Council.

On the other side of the debate are the members who believe it is
too early to know in which direction the economy and financial markets
are evolving, sources say.

Given the recent market turbulence over Ireland and Portugal, they
fear that rushing too quickly into additional liquidity withdrawal could
put unnecessary stress on markets that are already uncomfortably
volatile. Slowing EMU growth, a darkening economic picture in the U.S.,
a soaring euro, and a lack of any significant inflation pressure are
other reasons, they believe, why it would be wise to wait.

The senior Eurosystem official said discussions are increasingly
centering on the idea of a possible return to variable rate refinancing
operations on three- and one-month operations sometime after the start
of new year. But if the ECB did this, the official said, it would
continue to provide large volumes of liquidity in those auctions.

The idea, if it were accepted by the Council, would be to leave the
pump on but at the same time “send a signal that we’re making it a bit
harder for you to get the money,” the senior source said. He argued that
variable rate auctions on three- and one-month funds could co-exist for
some period of time with an official interest rate of 1%. The ECB would
also presumably continue to conduct its weekly main refinancing
operations on a fixed-rate, full-allotment basis.

However, there are other Eurosystem officials who believe that
returning to competitive bidding on three- and one-month tenders would
inevitably send an interest rate hike signal to markets, which the ECB
does not want to do.

In any event, a decision does not appear imminent.

“There is still much concern within the Council regarding the exit
strategy,” the senior source said. “It is too early to tell when the
exit will take place, and the next three months are very crucial. Much
will depend on the state of the financial system.”

He added: “The latest ECB analysis show that certain banks on the
periphery of the Eurozone still face problems and any premature decision
for an exit strategy will create further instability.”

The so-called “addiction” of those problem banks to ECB funding is
of increasing concern to Council members, as reflected in recent public
comments by Bank of Italy Governor Mario Draghi, who said national
authorities must take measures to address the problem, “otherwise we’ll
have zombie banks in the EU.”

Other Eurosystem officials have also said the solution must be at
the national government level, and some concede it could be a very slow
process that keeps the ECB on the hook for some time to come.

“It’s a long route out [of dependence on ECB funds]. There are
still issues of trust in the markets. The answer is slow consolidation
and wind-downs of the worst cases,” said a second well-placed source.

“So it’s between bad choices and worse choices,” he lamented. “That
scenario is playing out country by country, and in that sense it is out
of the hands of the ECB. Consolidation comes slowly but it is handled
domestically. We can only encourage it.”

This official added that “in principle there’s a good consensus”
around the idea that the ECB must keep supporting troubled banks via
liquidity as long as it’s needed.

But others would disagree. The senior Eurosystem source said that a
group of more hawkish Council members, led by Bundesbank President Axel
Weber, is pushing the idea of higher haircuts on Irish and Greek bonds
that are posted as collateral in ECB refinancing operations. This would
presumably cap the volume of funds that Irish and Greek banks could
borrow from the ECB. The argument of those who promote this idea is that
those banks should know they “cannot get away with the ECB always being
there,” the senior official said.

He said their proposal is being resisted by another faction on the
Council, led by some members of the Executive Board, who believe that,
“if we do that, we will send the wrong signal to the market and will
create chaos because countries like Ireland cannot help themselves.”

Still, the second source conceded that, “all avenues are discussed
and all avenues are open — and that includes revising the system for
haircuts.” He added: “You can make it tighter. It’s a case of finding
the right balance and moving when the time is right. And understandably
you need to be cautious.”

Beyond worries about liquidity and “addicted banks,” the sources
expressed caution with regard to the Eurozone’s economic prospects,
particularly in the face of a worrying economic picture in the U.S.

“You will still hear a cautious assessment from the ECB on the
outlook. That won’t change,” one of the officials said. “No one ever got
carried away, and the most recent data on exports and activity have been
more realistic, and maybe more sobering. There are still clearly major
differences among countries — clear imbalances.”

This official added that “the U.S. situation is being followed and
analyzed. It’s not great for the euro area, but I don’t think it’s
causing lost sleep yet.”

The senior Eurosystem source seemed to signal a slightly higher
degree of concern about economic developments on the other side of the
Atlantic.

“Our eyes are mainly turned to the United States, where there is a
slowdown and we do not know yet whether it is temporary or not,” he
said. “There is loss of momentum that might affect economic activity and
private consumption in Europe if it is medium-term.”

This official added: “The U.S. might need to proceed with
quantitative easing and close-to-zero interest rates for a longer period
of time.”

That of course could put additional upward pressure on the euro,
which would not be quite the economic balm that the Eurozone needs right
now. The senior source hinted at some concern about the euro’s exchange
rate, though not directly vis-a-vis events in the U.S.

“The ECB is carefully monitoring developments in the Japanese
economy, as we do not approve of fluctuations in the foreign exchange
markets,” he said. “The move of the Bank of Japan to devaluate the yen
might not have the results Japan wants in the medium term. But it is not
the time to draw a conclusion as to whether it will result in [further]
appreciation of the euro.”

–Paris newsroom, +331-42-71-55-40; paris@marketnews.com

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