How do the ECB's exceptional measures work?

10th May 2010, Comments 0 comments

The European Central Bank unveiled Monday exceptional measures aimed at ensuring that eurozone governments and banks will be able to get critical financing in the coming months.

Following are the measures announced by the ECB and how they work.

- Purchases of public and private debt:

The ECB said it would "conduct interventions in the euro area public and private debt securities markets to ensure depth and liquidity in those market segments which are dysfunctional."

This is the first time the ECB and its constituent central banks have bought public debt, and is highly controversial because if it extends over a long period it amounts to financing a country's debt.

That would reduce the incentive to cut such debt, creating what is known as a moral hazard.

The move means eurozone central banks, which are members of the ECB, could buy Greek government bonds from commercial banks for example, since the ECB cannot buy government debt directly.

By doing so, the ECB ensures a market for Greek (or Portuguese or Spanish or other) government debt at interest rates low enough to allow debt-wracked countries to pursue budget consolidation.

That is crucial to a long-term resolution of the problem.

The central banks plan to buy debt on condition that governments have taken "all measures needed to meet (their) fiscal targets this year and the years ahead in line with excessive deficit procedures," an ECB statement said.

Debt purchases will be "sterilised," or offset by the sale of other central bank assets to avoid having to print euros to buy the bonds, which would fuel inflation.

- Full allotment on three- and six-month refinancing operations:

The ECB will resume its exceptional policy of unlimited loans of central bank funds for three- and six-month periods, at a fixed rate of probably one percent for the former, and a rate likely to be close to one percent for the latter.

This will allow banks to obtain all the central bank cash they need and is aimed at calming interbank lending markets that have begun to freeze up again.

Banks become wary of lending to one another if they are unsure the borrower will be able to pay the money back, because of exposure to risky Greek debt for example.

Such a situation occured after the US investment bank Lehman Brothers collapsed in September 2008, and eased only after the ECB and other central banks repeatedly pumped massive amounts of cash into interbank markets.

- Reactivation of temporary liquidity swap lines with the US Federal Reserve:

Decided in coordination with central banks in Britain, Canada, Japan and Switzerland, this is the trading of currencies in exchange for dollars that are then offered to banks in the respective countries or currency zones.

As in refinancing operations, commercial banks must place collateral with central banks in exchange for the dollars, but are then sure of getting as much of the US currency as needed to keep the respective economies well supplied.

Once again, the goal is to ensure money markets are amply supplied to ward off fears they might dry up, which can then become a self-fulfilling prophecy.

© 2010 AFP

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