South's cash addiction to force continuing ECB drip
FRANKFURT (Reuters) - The European Central Bank will have little option but to keep flooding the money market with cash to aid banks and governments in the common currency area's troubled southern periphery, despite robust growth in the core.
Southern Europe has been hit hard on several fronts recently. First the sovereign debt crisis hit Greece and other southern periphery countries, then bank stress tests showed 6 out of 7 failing banks were in Spain or Greece, and then the region posted only tepid growth while most of the euro zone was humming along nicely, all weakening confidence in banks.
Bank borrowing from the ECB shows increasing strains in southern euro-zone's financial sector while banks elsewhere are getting back on their feet, but the fear of contagion from country to country will keep the ECB on its toes.
Total use of ECB funds has dipped in recent months, but southern periphery banks rely on the ECB in the face of continued reluctance among peers to lend.
Analysts said this would reinforce the argument for the ECB to extend its unlimited cash offers into next year -- an outcome looking increasingly likely after Germany's Axel Weber joined other policymakers in backing an extension on Friday.
Banks in Greece borrowed twice as much last month as they did in July 2009, even though outstanding central bank lending fell 18 percent over the same time. Banks in Portugal borrowed five times as much in July 2010 as they did a year earlier, and borrowing also rose in Spain and Italy.
"The full-allotment fixed-rate repos will stay well into next year," said Michala Marcussen, Societe General chief economist.
"Beyond the first quarter of next year, the overall economic environment will be the key determinant in how much longer it gets carried. In all likelihood it could get carried further ahead."
The ECB introduced unlimited fixed-rate loans in October 2008 and has promised to keep them in place in the shorter-term, one week and one month operations until at least mid-October, and until the end of September for three-month money. Fourth-quarter plans are due to be revealed in September.
The ECB tried to reintroduce limits to borrowing in April but was forced into a U-turn by the sovereign debt crisis, returning to its full allotment policy in May.
Cyprus's Athanasios Orphanides and Ireland's Patrick Honohan have indicated the unlimited funding should continue. But Weber made clear exit discussions should not resume until early next year and his dovish tone got analysts' attention.
"The key message is that the ECB is willing to stay there as long as it has to and that it believes that it needs to be present and keep those full allotments," Marcussen said.
There were great hopes that last month's bank stress tests, the latest salvo in the battle to improve confidence, would calm the market but their impact is already waning after muted positive signals at first.
"There has to be increased confidence of health or the perceived health of the banking system (for phasing out crisis measures)," said RBS economist Nick Matthews.
"The stress tests were an opportunity to do that, but it does seem as though some of the positive results seem to be wearing off, so maybe these stress tests were a missed opportunity."
Only seven of the 91 banks tested failed, and some analysts thought the scenarios were too lenient.
The euro zone is seeing an increasing split not only in banking, but in the economy as a whole, further complicating the ECB's task. While the euro-zone economy boomed in the second quarter with Germany setting the tone, southern Europe recorded much more muted growth.
The ECB stresses consistently its policy takes into account the whole of the euro zone, not individual countries.
"I think it is a challenge that we had to face permanently since the very beginning of the euro," Trichet said earlier this month, brushing off concerns that uneven economic development was an especially pressing problem right now.
But neglecting banks' difficulties even in relatively small countries would exacerbate the economic split and threaten to get the south mired in a credit crunch.
Moreover, the Greek debt crisis showed that developments in one small country can have dramatic implications for others, and banks are dependent on each other across borders.
"Because of the interlinkages between the European banking systems, if there are issues in one country, these will domino into other countries," SocGen's Marcussen said.
"It is not just about supporting the peripheral countries, it about offering support to the European banking sector."
The ECB's promise of continued unlimited funding would reduce uncertainties and give banks and governments time to bridge their credibility gap.
Liquidity injections have an important role not only in helping banks, but also in easing government financing woes, as sovereign bonds can be used as collateral against ECB loans, making them more attractive to banks, analysts said.
"The ECB is not just financing the banks that obtain funds more cheaply, it is also financing the governments (through the tenders)", said Filipe Garcia, an economist at the Informacao de Mercados Financeiros in Porto, Portugal.
The central bank would not be doing its job as guardian of the economy were it to ignore problems in the south, he added.
"If the ECB was not present, it would not be assuming its role as a central bank," Garcia said.
(Additional reporting by Axel Bugge in Lisbon and Krista Hughes in Frankfurt; editing by Patrick Graham)
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