(Adds comments from Nowotny, economist; background)
By Sakari Suoninen and Paul Carrel
FRANKFURT, July 25 (Reuters) - European Central Bank Governing Council member Ewald Nowotny has broken ranks with ECB colleagues, saying that giving Europe’s permanent rescue fund a banking licence to increase its capacity had merits.
Granting the fund, the European Stability Mechanism (ESM), a banking licence would allow it to exchange bonds it buys to support highly indebted countries for fresh cash from the ECB, increasing its firepower without additional government funds.
ECB President Mario Draghi has poured cold water on the idea and legal problems could also prevent the central bank allowing the ESM to tap its liquidity operations, but Nowotny’s comments show the intensifying euro zone crisis is pushing policymakers to think about policy options they have previously shunned.
Asked about giving the ESM a banking licence, Nowotny told Bloomberg in an interview released on Wednesday: “I think there are pro arguments for this.”
The Austrian central bank governor’s comments pushed the euro higher and European shares turned positive on the idea that the euro zone bailout fund’s firepower to tackle the region’s deepening debt crisis could be boosted.
Nowotny, however, said the issue was far from settled and that it was not being actively discussed right now - an indication that, if were to be considered, it would take time to agree on the measure.
“There are also other arguments, but I would see this as an ongoing discussion,” he said, adding that he was “not aware of specific discussions within the ECB at this point.”
France has been behind a push to give the ESM access to ECB funding operations.
The ECB has repeatedly rejected the idea, arguing it would be thinly disguised monetary financing of governments. The ESM is an entity that is funded by governments.
Monetary financing has been a taboo for the ECB, though when asked in a weekend newspaper interview about doing more to support the economy, ECB President Mario Draghi said: “We are very open. We do not have any taboos.”
At a news conference on July 5, Draghi was asked about the ECB’s view on granting the ESM rights to participate in ECB liquidity operations, and said it would have grave consequences.
“Right now, the ESM and the EFSF with the new modalities are big enough to cope with the contingencies that we can envisage now,” he said.
“I don’t think there is anything to gain in destroying the credibility of an institution, asking it to behave outside the limits of its mandates.”
The ECB cut interest rates to a record low of 0.75 percent at its July policy meeting, showing it is ready to take unprecedented action to tackle the crisis.
The crisis threatens to escalate further over the summer as Spain faces borrowing costs economists say are unsustainable. EU also officials say Greece has little hope of meeting the terms of its bailout, casting fresh doubt on its future in the bloc.
The euro zone has said it will keep Greece afloat through August while the troika of European Commission, IMF and ECB inspectors assesses Athens’ compliance with the terms of its bailout but a crunch point looms in September or October.
Greece is unlikely to be able to pay what it owes and further debt restructuring is likely to be necessary, three EU officials said on Tuesday, a cost that would have to fall on the ECB and euro zone governments.
Some euro zone officials are less concerned about the hit the ECB would take from such a writedown than about the contagion effect - foremost the risk of a further deterioration in markets’ confidence in Spain.
“It is understandable that the ECB is reluctant to offer more explicit support to sovereigns,” JP Morgan economist David Mackie wrote in a research note. “But, if Spain and Italy lose capital market access, there will be no alternative.”
“A large scale sovereign default would create massive financial disruption and drive the region into a deep recession with deflation. None of this would be consistent with the ECB’s mandate,” said Mackie.
Weakening growth in Germany, the euro zone’s largest economy and paymaster for the bailouts, as well as slowing inflation could give the ECB cover to take further policy action - either with rate cuts or perhaps something more radical.
German business sentiment dropped in July for the third straight month to the lowest level since March 2010, in a sign that a renewed flare-up of the euro zone crisis is not sparing businesses in Europe’s largest economy.
“Growth dynamics for the euro zone as such are tending to be lower than we had been expecting at the start of the year,” Nowotny said. “Inflation also tends to be lower”.
Nowotny also said the central bank saw no deflation, or persistently falling prices, in the euro zone.
He did not rule out further interest rate cuts, which could involve cutting the rate the ECB pays banks to deposit funds with it overnight into negative territory, but said this “has to be decided at a later stage.”
The ECB rarely takes monetary policy action in August, and has not done so since 2006.
Additional reporting by Eva Kuehnen; Editing by Jeremy Gaunt