ECB moves to back Italy and Spain

The European Central Bank made record purchases of government bonds last week, it reported Monday, going further than many analysts had expected to hold down the borrowing costs of Italy and Spain, two of the largest countries caught up in the continent’s debt crisis.

The $30 billion in government debt purchased by the central bank last week eclipsed the previous $20 billion bought in the days after it agreed last year to use its financial power to help restrain interest rates paid by weakened European governments. Increasing the demand for a government’s bonds lowers the interest rate it pays.

The aggressive intervention offered evidence of the ECB’s effectiveness — Spanish and Italian borrowing costs dropped by a full percentage point after a spike — but it also underscored the extent of the challenge facing Europe’s policymakers.

European leaders approved what they regarded as a dramatic set of steps in late July to convince global investors that the 17 nations that share the euro currency are solvent and will pay their bills.

Yet borrowing costs for Italy and Spain still soared, contributing to a recent sell-off on global stock markets and forcing the Brussels-based bank to further revise its role. From an institution almost solely focused on controlling inflation, the ECB has become a key backstop for strapped European nations like Greece, Ireland and Portugal — holding an estimated 16 percent of their outstanding debt after a year of at-times aggressive buying.

The bonds of Italy and Spain were reluctantly included in the ECB’s purchases last week as the bank expanded its role in preventing deeper economic problems for the euro. Although the ECB does not provide a nation-by-nation account of its bond purchases, analysts assume that the billions added to the overall holdings by the middle of last week were used to buy the bonds of those two countries. A default or bailout of either nation would be calamitously expensive and threaten French and German banks heavily invested there.

The ECB now holds about $140 billion in government bonds. The question is how much further it will need to go in coming weeks — and whether its governing council is willing to keep the checkbook open. Some analysts here wonder whether European politicians can come up with a durable solution to the currency’s problems before the central bank runs out of patience or pulls back out of concern that its own stability could be endangered by carrying so much government debt.

The ECB “sterilizes” its bond purchases by taking interest-bearing deposits from other commercial banks, withdrawing an equivalent amount of money from circulation so that its bond purchases don’t increase the supply of euros and potentially add to inflation. That could become more difficult if its bond holdings continue to expand. The program also, some argue, is forcing the bank into a new role that clouds its mandated mission of controlling the money supply and inflation.

“What is important is to have a division between the central bank” and the government tax and spending policies of the euro nations, said Peter Bofinger, an economics professor at the University of Wuerzburg. “The more you blur it the worse for the independence of the central bank.”

Ultimately, bank officials say they hope their efforts will be replaced by the new programs approved recently by European governments.

Those programs will set up a common fund to buy the bonds of heavily indebted European nations. But the initiatives must still be approved by national parliaments and may be months from becoming operational.

The ECB bond purchases last week, which were larger than anticipated by a group of economists polled by Bloomberg, reflect a euro crisis that could be entering a decisive phase.

Since the July meeting of European leaders, more ambitious ideas — such as the establishment of a common eurobond issued jointly by the 17 nations — have gained momentum. French President Nicolas Sarkozy and German Chancellor Angela Merkel are to meet Tuesday to discuss the next steps in addressing the crisis. While their spokesmen said the eurobond idea is not on the agenda, there have been wide calls for some effort to resolve the continent’s debt crisis once and for all.

The increase in ECB purchases “has upped the ante,” analysts from Capital Economics wrote. But “no matter how many government bonds it buys, the ECB will not magically resolve the fundamental economic and fiscal problems faced by their issuers.”

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