EUROPE´S CENTRAL BANK FACES CREDIBILITY TEST / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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JULY 2, 2011.

Europe's Central Bank Faces Credibility Test .

By BRIAN BLACKSTONE

FRANKFURT— The European Central Bank, still trying to restore its reputation after a series of policy reversals last year, will face a new test of its credibility in the coming weeks if it is forced to decide whether to cut Greek banks off from its funding facility.


At issue is whether Greek bond rollover proposals under consideration by the private sector and governments are deemed a default by rating agencies. If that occurs, ECB officials have warned Greek debt will be rejected as backing for the ECB loans that are crucial to that country's banks.


If the ECB were to change course again to save the banking system, it would do even deeper damage to its reputation and freedom from political pressure than last year's reversals on its collateral rules and stance on buying government bonds, analysts say.


"Once you make those U-turns, they ingrain some doubt about ECB actions," said Raoul Ruparel, an analyst at the think tank Open Europe in London. "People are always going to have that in the back of their minds."


ECB officials have left little if any room for compromise on Greece, saying their rules forbid them from accepting Greek government bonds as collateral under a default, an action that would throw the Greek economy into turmoil and threaten the rest of Europe.


The ECB has reason to hang tough for now. Its balance sheet, at nearly €2 trillion ($2.9 trillion), is the highest since the beginning of the year and includes more than €70 billion in government bonds of its weakest members. The ECB doesn't provide a breakdown, but economists estimate as much as €40 billion or more are in Greek bonds. In addition, the ECB holds tens of billions of euros in collateral for loans to commercial banks in Greece, the value of which could crumble in the event of default.


Euro-zone finance ministers on Saturday approved the release of the fifth tranche of Greece's existing bailout package. A second, larger, bailout package is expected to be approved later in the summer. Governments want the private sector to assist in that effort by agreeing to roll over some of their Greek bonds when they mature.


ECB officials have for weeks stressed that a mix of austerity and privatization of state-owned assets is the best course of action for Athens. While officials have said they support private-sector participation that is purely voluntary, they see the debate as a distraction.


The central bank's aura of independence was bolstered after ECB officials recently won a public face-off with some euro-zone governments, led by Germany, that wanted to extend the maturities of Greek bonds held by the private sector, a scenario that almost surely would have led to a default. Germany eventually backed down, and said it would only back a Greek debt deal with banks if the ECB approved.

Changing course now would undo those efforts and others the ECB has made in restoring the credibility it lost last May when it said it would buy government bonds just four days after saying the idea wasn't even under discussion. That decision caused a rift with the euro zone's strongest member state, Germany, where it was perceived as a dangerous blurring of monetary and fiscal policy that threatened stability and ECB independence.


"Central banks should not get involved too deeply in crisis management that is clearly a fiscal issue...then the central banks lose their independence" by becoming "part of political deals," former Bundesbank president Axel Weber said in a recent interview.


But the ECB has refrained from buying bonds for three months even as the Greek crisis raged and Irish and Portuguese bond yields approached euro-era highs. It raised interest rates in April—the first major, developed-country central bank to do so—and has strongly hinted it will do so again when it meets Thursday, a signal that it won't allow Greece to disrupt the euro bloc's interest-rate settings.


"The ECB has been flexing its muscles" after being "very much on the back foot last year," said Philip Whyte, an analyst at the London-based Centre for European Reform. Still, "the threat the ECB is wielding (to reject Greek bonds) is a threat you might say it can never actually carry through given the consequences it would unleash."


Officials are under enormous pressure not to cut Greece off. The Institute of International Finance, a trade group representing some of the world's largest banks, said Friday that support for Greek banks is "crucial" until they are able to access markets again.


Daniel Gros, head of the Center for European Policy Studies in Brussels, expects the ECB's anti-default position to prevail for now, with the likeliest scenario being that rating agencies don't classify rollovers as default. But the issue will come back given Greece's huge debt burden, he warns, putting the ECB's credibility on the line once again.


"It's a power play, and victories in power plays are usually pyrrhic," he said.
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Mixed Signals
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Some of the European Central Bank's notable shifts in policy over the past year


January 2010: ECB President Jean-Claude Trichet said the central bank wouldn't change its collateral rules 'for the sake of any particular country.' In May 2010, it suspended those rules for Greek government bonds.


March 2010: Mr. Trichet said it wouldn't be 'appropriate' for the International Monetary Fund to supply assistance for Greece. The IMF later became a major part of the Greek rescue, in conjunction with the European Union.


May 2010: Mr. Trichet said the ECB, at its monthly meeting, 'did not discuss' whether to buy Greek bonds. Four days later, the ECB announced it would purchase government bonds to ensure the smooth functioning of markets.
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