UPDATE 3-Draghi sends strong signal that ECB will act

by on July 26, 2012 3:21 pm BST

Thu Jul 26, 2012 11:21am EDT

* Draghi says ECB will act to save euro

* Says addressing too high borrowing costs within mandate

* Italy, Spain fall sharply on hopes of action

* French finance minister welcomes statement

By David Milliken and Marius Zaharia

LONDON, July 26 (Reuters) – European Central Bank President
Mario Draghi pledged on Thursday to do whatever was necessary to
protect the euro zone from collapse, sending a strong signal
that inflated Spanish and Italian borrowing costs were in his

Fears about the euro zone’s future are intensifying with
Spain and Italy facing frenzied pressure on financial markets
and Greece holding crunch meetings with its international
lenders having failed to keep its repair plans on track, raising
fresh questions about its place in the currency bloc.

With the need for urgent action becoming increasingly
apparent, the ECB appears to be gearing up to flex its muscles,
something Madrid and Rome have been seeking for months.

“Within our mandate, the ECB is ready to do whatever it
takes to preserve the euro. And believe me, it will be enough,”
Draghi told an investment conference in London to mark the
beginning of the Olympics.

“To the extent that the size of the sovereign premia
(borrowing costs) hamper the functioning of the monetary policy
transmission channels, they come within our mandate,” he said.

The ECB has cut interest rates to record lows and offered
banks unlimited liquidity without any meaningful boost to the
euro zone economy or bank lending resulting.

The comments are Draghi’s boldest to date and suggest the
central bank is ready to defend Italy and Spain whose borrowing
costs have hit unsustainable levels.

Winding up his remarks to an audience of business leaders,
he said: “I think I will stop here. I think my assessment was
candid and frank enough.”

The euro jumped above $1.23 for the first time in two
weeks after his remarks, Spanish and Italian bond yields fell
sharply and the index of leading European shares jumped more
than two percent.

After defending Italy last year, the ECB has kept its
sovereign bond-buying programme mothballed for months. Internal
opposition to reviving it is stiff so focus will turn to what
else the ECB could do following Draghi’s remarks.

Economists think despite the reservations it could be forced
to buy bonds again, or support struggling euro zone countries
via the back door.

On Wednesday, ECB policymaker Ewald Nowotny broke ranks with
his colleagues, saying that giving Europe’s permanent rescue
fund a banking licence so that it could drawn on central bank
funds had merits. Draghi and others have previously rejected
that option.

Alternatively, the bank could act as the Federal Reserve and
Bank of England have, and opt for straight quantitative easing
— money-printing by another name.

“The comments about high government bond yields disrupting
ECB monetary policy transmission are interesting, in so far as
they hint at a possible attempt to circumvent the restrictions
on outright government bond purchases,” said Marc Ostwald,
Strategist at Monument Securities.

“Of course it remains to be see whether Herr Weidmann, Herr
Asmussen, Frau Merkel and Herr Schaeuble would agree with his
assessment,” he said, referring to the senior members of the
German government and its representatives at the ECB.

French Finance Minister Pierre Moscovici said Draghi’s
remarks on government bond yields were “very positive”, adding
that the euro zone should also not ignore the option to use its
EFSF bailout fund to buy bonds.

The IMF also gave its approval. “Draghi’s remarks are a
welcome reiteration of the ECB’s well-known commitment to do
what is necessary,” a spokesman for the fund told a news


The ECB rode to the rescue at a previous moment of acute
stress in December, launching a programme that eventually
created more than 1 trillion euros of three-year liquidity for
the currency area’s cash-strapped banks. That bought three
months of market calm which now seems a distant memory.

Its members have been steadily upping their rhetoric in
recent weeks as delays in getting the euro zone’s bailout fund
up and running and Spanish banks recapitalised has pushed the
euro zone crisis back to boiling point.

Euro zone powerhouse Germany was put on a rating downgrade
warning this week along with fellow AAA members the Netherlands
and Luxembourg.

Draghi said at the weekend that the ECB had “no taboos” over
what it could or could not do. His fears about the failing
transmission of record low interest rates and uber-cheap loans
into the real economy chime with similar warnings from Bank of
France head Christian Noyer.

Draghi’s remarks “suggest that he has either convinced the
German members of the ECB that it is time to intervene verbally,
and if necessary follow through with actual intervention, or he
is willing to risk a showdown knowing that a vast majority of
the Council will support him,” said Riccardo Barbieri, chief
European economist at Mizuho International.

A crucial issue for the euro zone is that its bailout fund
would not be able to cope with supporting a country as large as
Spain or Italy without a major injection of firepower. In the
absence of that, the ECB is the only line of defence.

Draghi stressed that the ECB did not want to do things that
should be done by governments. He refused to speculate on the
chance of a country leaving the euro but said that the single
currency was “irreversible”.

“Our job is to maintain price stability in the medium-term.
Our job is to cope with financial fragmentation, when it falls
within our mandate,” he added.