FRANKFURT (Reuters) - The European Central Bank this week will try to calm investors worried about the euro zone crisis flaring up again, pledging to keep the banking system lubricated after Cyprus's brush with financial meltdown.
The central bank is widely expected to hold off an interest rate cut this month, instead waiting to see if a grim economic picture in the euro zone brightens before using its limited remaining margin for manoeuvre to lower borrowing costs further.
ECB policymakers meet against a backdrop of bleak economic data and concern Slovenia could follow Cyprus and seek a bailout. A Reuters poll last week pointed to interest rates remaining on hold deep into next year. The ECB's main rate stands at a record low of 0.75 percent.
"I think it's too early, but one more round of bad numbers and I think we will hear (ECB President Mario) Draghi signal a near-term rate cut," said Nordea analyst Anders Svendsen.
Underlining the euro zone's economic weakness, a business survey on Tuesday showed manufacturing across the bloc fell deeper into decline in March. The Cyprus bailout crisis - involving large losses for some depositors - has yet to take a toll on factory activity.
To ensure the euro zone financial system is funded properly, the ECB is already offering banks unlimited liquidity with loans up to 3 months, and reserves the option to provide them with more funding certainty over a longer horizon by laying on another 3-year funding operation, as it did a year ago.
The ECB has said emergency liquidity will be provided to Cyprus banks in line with its rules, which require banks to be solvent. It could also buy sovereign bonds if the country concerned accepts the austerity required for ECB intervention.
Despite the ECB's suite of policy options, markets remain nervous, unnerved by Cyprus's problems and by political stalemate in Italy. Euro zone bond markets began the week cautiously with peripheral bond yields at elevated levels.
Investors will be looking to Draghi for reassurance. Many are betting Slovenia will be next to need a rescue, though Finance Minister Uros Cufer told Reuters last week the country would not need one this year.
"It's not just the Cyprus debacle, there are also growing worries about Slovenia and the latest data has taken a downturn in March," said Howard Archer, economist at Global Insight. "I'm sure he'll do his best to sound reassuring on all fronts."
Nomura economist Nick Matthews expected Draghi to reinforce his message that the ECB is ready to do 'whatever it takes' within its mandate to preserve the euro - a line the Italian deployed last July to suck the heat out of the crisis.
"As part of this, Draghi will likely emphasise that the ECB stands ready to provide as much liquidity as required for the banking sector (including for Cyprus), within the rules," Matthews added.
The ECB's 23-man Governing Council discussed cutting rates last month, when Draghi said economic activity should recover gradually later this year.
With its main rate at 0.75 percent, the ECB has some room to lower borrowing costs though its deposit rate - the rate it pays banks to park money with it overnight - is at zero and Council members are reluctant to take it into negative territory.
Asked in a newspaper interview published last Thursday whether the ECB had any margin to cut rates further if the economic outlook deteriorated, ECB policymaker Yves Mersch said in theory yes, but there was no sign of this happening so far.
"Obviously, in theory there is margin (for that). That said, your question implies the possibility of a deterioration in the outlook, something which there is no clear evidence of yet," Mersch told Spanish newspaper Expansion.
But Tuesday's purchasing managers' survey pointed to fresh deterioration as manufacturing across Europe's major economies endured another month of mostly deep decline in March.
Another dose of weak data could see the ECB change tack and signal a cut, said Nordea's Svendsen: "We have enough things now on the agenda that could potentially have a negative consequence for the key figures, so I think we're at an inflection point."
Editing by Jeremy Gaunt.