ECB may need €2.5 trillion to save Europe

A chorus of global economists has called on the European Central Bank to go far beyond pin-prick purchases of euro zone debt and launch quantitative easing (QE) on a massive scale to head off a euro zone debacle, if necessary purchasing half the entire stock of Italian and Spanish debt.

Stephen King, HSBC’s chief economist, said the ECB should drop its ideological opposition to QE and embrace easy money same way as the US Federal Reserve.

“At the heart of the problem is the ECB’s unwillingness to be seen ‘monetising’ government debt. Yet if the alternative to QE is the collapse of the euro or a descent into depression, then massive expansion of the ECB’s balance sheet seems a small price to pay,” he said.

The ECB should not “sterilise” purchases of Italian and Spanish bonds to offset stimulus but instead allow the liquidity to course through the system. King said the euro zone will have to embrace fiscal union in the end or face the same sort of “fiscal anarchy leading to financial implosion” that destroyed the post-Soviet rouble area.

New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. “It should reduce rates to zero, and make big purchases of government bonds,” he said.

Frankfurt is unlikely to heed the advice. The bank’s president Jean-Claude Trichet, last week stuck to his anti-inflation script and said: “We do not do QE.”

The ECB began buying Spanish and Italian bonds for the first time on Monday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.

Investors have not forgotten that the ECB failed to stop Greek, Irish, and Portuguese yields from spiralling out of control before each needed a rescue, even though it purchased almost a fifth of their combined debts.

Jacques Cailloux, Europe economist at RBS, said the ECB’s intervention had stopped a collapse of South European bond markets for now, but ultimately the ECB will have to act as buyer-of-last-resort on a huge scale. Investors will take advantage of bond rallies to cut exposure to Italy and Spain, shifting the risk onto the ECB and the taxpayer.

The crisis will flare up again if the ECB stops buying. Cailloux said private investors will not return to the market until debts of Italy and Spain are on a “declining trend” and there is no longer any serious risk of contagion.

“That simply cannot happen in the foreseeable future. Over time, we believe that ongoing selling pressure will force the ECB - and (the eurozone’s bail-out fund) the European Financial Stability Facility (EFSF) - eventually to hold close to half the long-term traded debt of Spain and Italy or around €850 billion (£738 billion). This huge risk-pooling will not come easily and the risk of political fallout will be large,” he said.

The ECB acted on the assurance that the EFSF will take over the responsibility once its new powers have been ratified by national parliaments, which may not be until October. This creates an implicit limit on ECB purchases since the fund is not authorised to lend its full €440 billion, and a large chunk of that is already earmarked for Greece, Ireland and Portugal.

Brussels has called for more firepower and Citigroup has called for a €2.5 trillion fund to silence all doubts. Yet this is anathema to Berlin, where key figures on Chancellor Angela Merkel’s coalition are near revolt.

Despite the ECB’s desperate intervention, economists said it had only bought time for a deeper political solution. Economists are unanimous that only an increase in the eurozone bailout fund, the European EFSF, from €440 billion to as much as €2 trillion will provide sufficient emergency firepower to restore market confidence.

But, a weekend statement by Merkel and French president Nicolas Sarkozy made no mention of boosting the fund.