Trichet May Need to Rewrite ECB Rule Book to Tame Greek Threat

NEWYORK, May 4 -- European Central Bank President Jean- Claude Trichet, who capitulated on a January pledge not to relax lending rules for the sake of one country, may have to sacrifice more principles to prevent Greece from bringing down the euro.

Trichet yesterday diluted rules for the second time in a month to guarantee the ECB will keep taking Greek government bonds as collateral for loans. The central bank may have to extend that to other nations, renew a program of lending unlimited cash to banks for a year, and even start buying government debt if the 110 billion-euro ($146 billion) bailout plan for Greece fails to stem the euro's slide, economists said.

"Rather you break the rule book than the euro area," said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. "We're far from being out of the woods. There is now a real opportunity for the ECB to take the lead."

Pressure will grow on the central bank to become more aggressive if investors remain concerned about budget deficits in Greece and other debt-strapped euro nations such as Portugal and Spain. While Greek bonds rallied on the rescue package, two- year bonds still yield more than 10 percent. Portuguese and Spanish yields were little changed near decade highs and the euro extended its drop against the dollar this year to 9 percent.

'Ready to Do More'

"The ECB has to stand ready to do more," said Nick Kounis, chief European economist at Fortis Bank Nederland NV in Amsterdam. "The ECB has been involved in technical work, but it's not really been a key player when it comes to getting us out of this mess."

Greek 10-year bonds yield about 8.5 percent, some 550 basis points more than German bunds. That spread is down from as high as 800 basis points last week, the biggest gap since the euro's introduction 11 years ago.

The threat of contagion has grown as policy makers squabbled over how to deal with Greece, just as the near- collapse of Bear Stearns Cos. in 2008 eroded confidence in other U.S. banks.

Spain's budget deficit was the third-highest in the euro region last year at 11.2 percent of gross domestic product, while Portugal had the fourth-biggest at 9.4 percent of output. Ireland's topped the list at 14.3 percent and Greece's was 13.6 percent.

"Despite fundamental differences, it remains impossible to rule out a self-fulfilling crisis," UBS AG Chief European Economist Stephane Deo wrote in a research note to clients.

Next Steps

The next response to a broadening loss of confidence in euro-area finances would be for the ECB to channel cash through banks, either by lending them more for longer in its regular auctions or by weakening collateral rules further, Deo said. Another option would be to accept bank loans to governments as security, he said.

The ECB may have to go even further and buy government bonds if it is to stabilize financial markets and avoid a return to recession as governments slash spending to appease investors, said David Owen, chief European economist at Jeffries Group Inc. in London. "There is a good chance the ECB will ultimately have to resort to quantitative easing," he said.

While the ECB is prohibited from buying assets directly from authorities, it can buy them on the secondary market. Trichet said on May 2 that "at this stage, we have absolutely no decision on the purchase of government bonds."

‘Anathema' to Germany

Such a strategy remains unlikely because it would be a "red line which the German government would not allow to be crossed," said Marco Annunziata, chief economist at UniCredit Group in London. "Purchases of government bonds would be a straight monetary financing of excessive fiscal deficits, which is anathema to the Bundesbank and German government."

Still, the ECB said yesterday it would accept all Greek government debt as security when lending to banks, reneging on Trichet's pledge in January that it would not loosen lending requirements "for the sake of any particular country."

That prompted Christoph Rieger, co-head of fixed-income strategy at Commerzbank AG in Frankfurt, to say the announcement "leaves a sour taste with regards to the ECB's long-term credibility."

The loosening of ECB rules came as credit-rating downgrades threatened to render Greek government bonds ineligible as collateral and exacerbate the crisis. Standard & Poor's last week cut Greece's sovereign rating to junk status, below the minimum BBB- required by the ECB from at least one major rating company.

"Collateral policy was changed just for Greece when they said they wouldn't act for a single country," said Cailloux. "If the contagion filters through the financial system and the euro area is under threat, I can't imagine the ECB would stand on the sidelines watching the euro break up."