–Adds Comments On Stab Pact Reform, Creditor Haircuts, Exit Strategy

BERLIN (MNI) – The problems of Ireland’s banking system pose a risk
of contagion to other Eurozone countries, European Central Bank
Governing Council member Yves Mersch warned in a newspaper interview
released Wednesday.

The central bank president of Luxembourg also blasted the
Franco-German proposal for reform of the EU’s Stability Pact as too lax
and advised against a preconceived mechanism to make creditors shoulder
the risks of an eventual sovereign debt restructuring.

Asked by the German daily Die Welt whether investors’ mistrust of
the Irish banking system could spill over to all highly indebted
Eurozone countries, Mersch replied, “The danger cannot be ruled out.”

“I don’t believe one can criticize Ireland for not taking enough
measures,” he said. “The problem is that the country’s bank sector is
overstretched.”

“The decision to accept aid for its banks is entirely up to Ireland
alone,” he acknowledged. “However, the ECB will review its risk
management as well.”

According to the editors of Die Welt, this last phrase contains an
encrypted warning to Ireland that the ECB is not prepared to buy up
Irish government bonds eternally.

To banish this contagion risk, other governments must make the
reforms needed “to gain market confidence,” and appropriate structures
must be set up for the Eurozone as whole, Mersch said.

In this context, Mersch charged that the joint proposal of France
and Germany for reform of the fiscal Stability Pact “is the wrong way.”

“We need tougher deficit rules with automatic sanctions for
violations and surveillance of Eurozone members’ competitiveness,” he
said. “But what we are now seeing is not a greater sense for stability
but rather more political bargaining.”

Budget discipline cannot exist without automatic sanctions, he
declared, arguing that a stronger Stability Pact was needed to assure
the existence of the Eurozone over the long term.

Mersch said he hoped the European Parliament could resolve the
matter by taking account of a counter-proposal from the European
Commission that foresees automatic sanctions in the Stability Pact.

The central banker said he was not opposed in principle to the idea
that private investors should share the risks and eventual costs of the
insolvency of a Eurozone government, as Germany has proposed.

However, a rigid haircut mechanism would oblige investors to demand
a risk premium on sovereign Eurozone debts, he warned. He proposed
instead the flexibility practiced by the International Monetary Fund,
which preserves the option of creditor participation without making it a
rigid rule.

Mersch expressed optimism that other governments facing inflated
borrowing costs could regain investors’ confidence through appropriate
reforms. “If Greece remains on its consolidation course, it has very
good chances to pull its head out of the noose,” he said.

“Portugal has enough arguments to withstand contagion,” he added.
“While it has taken less dramatic steps than Ireland, it does not have
such a high deficit either. Nor do its problems stem from a real estate
bubble financed by the bank sector.”

“It is completely absurd to suppose that Spain could face
insolvency anytime soon,” Mersch continued. “The savings measures there
go much further than in many other European countries [and] bank
restructuring is off to a good start.”

In the internal ECB debate between President Jean-Claude Trichet
and Bundesbank President Axel Weber over the continuation of the
bond-buying program, Mersch sided, formally at least, with the majority
on the Council: “Since the umbrella was first opened, we have markedly
reduced the purchases and are assessing whether the unconventional
measures are appropriate.”

Mersch also underscored his previous warnings about leaving
interest rates too low for too long, citing the risks of heightened
investor risk appetite and delayed bank balance sheet consolidation.

The Federal Reserve’s new round of quantitative easing will not
derail the ECB’s exit strategy, he asserted: “We have always said we
will not be hostage to others. Our sole mandate is price stability in
the Eurozone. That implies a gradual normalization of our interest rates
and the unwinding of our exceptional measures, such as generous
liquidity supply.”

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