Europe's bold program to defuse its financial crisis by injecting cash into the banking system is running out of steam.
The European Central Bank's roughly €1 trillion ($1.31 trillion) of emergency loans caused interest rates of troubled euro-zone countries to plummet earlier this year, easing fears about Europe's debt crisis. But lately rates have again been marching higher.
One big reason: After months of using that cash to buy their government's debt, banks in Spain and Italy have little left, say analysts and other experts.
The banks' voracious buying had helped bring down the interest rates, providing relief for troubled countries that need to issue tens of billions of euros of bonds this year.
But the banks, lately the primary buyers of Spanish and Italian government bonds, no longer have much spare cash to continue such purchases.
That is sending rates back up, rekindling investor fears about Europe's ability to arrest the three-year-old sovereign-debt crisis and return the region to health.
The ECB had handed out the emergency three-year loans to at least 800 banks in two helpings, one in December and the other in February.
Banks used a big chunk of the money to snap up their governments' bonds, spurring sighs of relief from global markets.
The current strength of the ECB's rescue mission may be tested Thursday, when Spain, one of the euro zone's most troubled economies, auctions €2.5 billion of its bonds.
Despite a surprisingly strong sale of treasury bills on Tuesday, some experts worry that Spanish banks could be less active this time around, leaving Spain stuck with lackluster demand for its debt.That adds to worries that one of Europe's biggest economies might eventually need to seek financial aid from the international community.
"Eventually the liquidity extended [by the ECB] will be fully deployed, and at that point Spanish and Italian banks will either have to stop buying sovereign bonds, removing the largest buyer from the sovereign market, or sell bonds" to raise cash for their own needs, said Alan Broughton, an analyst at RBC Capital Markets.
The chief purpose of the ECB bailout was to keep the banks themselves well-funded. They have tens of billions of euros of their own debt coming due this year.
In that sense, the loans have succeeded: They have greatly reduced the risk that a European bank will suddenly run out of money and become an albatross around the neck of a weak country.
But the ECB's Long-Term Refinancing Operations, or LTROs, had a broader purpose: to get more money out into the wider economy, and especially to finance governments that had trouble borrowing on their own.
The cash "means that each state can turn to its banks, which will have liquidity at their disposal," French President Nicolas Sarkozy said in December, just after the first LTRO was announced.
In financial circles, the practice of banks' borrowing from the ECB in order to lend to their governments was dubbed the "Sarkozy carry trade."
In early March, ECB President Mario Draghi called the LTROs an "unquestionable success." Banks, he said, are having an easier time funding themselves, and international investors are tiptoeing back in.
"Certainly, we see many signs of a return of confidence in the euro," he said, adding that the loans offered European governments breathing room to get their fiscal houses in order.
European stock and bond markets stormed ahead in the first quarter, a sign of greater desire for riskier assets. By mid- March, European bank shares had rallied as much as 15% from the start of the year.
Bond yields in fiscally troubled European countries tumbled, a sign of waning investor fear, with Spain's 10-year bonds dropping from about 7% last November to below 5% in early March.
Weeks later, that confidence has ebbed.
Despite the new money sloshing around Europe, the fundamentals of the debt crisis are little changed: Spain and Italy both need sustained access to financing to cover their deficits.
If foreigners stay away and local banks run out of firepower, both countries will be back where they started before the LTRO.
A growing array of analysts and others worry that the flood of ECB loans in some ways could be counterproductive. The cheap money has reduced the urgency with which some banks are cleaning up their balance sheets, a trend that some critics worry could delay the industry's return to health.
Banks counter that what some see as foot-dragging is simply their trying to avoid a chaotic deleveraging process that could hurt the European economy.
"The market has been treating the LTRO as a panacea," said James Ferguson, head of strategy at Westhouse Securities in London. "It's absolutely better than what would have happened without it, but that doesn't mean it's a fix."
In theory, lending the local banks money they could in turn lend to the government at a profit buys time for the governments to enact overhauls that can lure back foreign investors.
That is essential: Both the Spanish and Italian economies run deficits with the rest of the world; their businesses and citizens don't generate enough surpluses on their own to finance the government.
But enticing foreigners has proved hard. Spain has relaxed its fiscal targets amid worries about the effect of austerity on its economy, and the International Monetary Fund projected Tuesday that Italy wouldn't meet its 2012 deficit target.
Data from Spain and Italy suggest local banks bought the bulk of the governments' new debt, and picked up a chunk of what foreigners were selling.
In Italy, domestic banks increased their holdings of Italian government debt by 29% in the three-month period ended February 2012, which includes the first of the ECB's two cash injections but not the second.
In Spain, banks took about €200 billion in ECB loans, according to analyst estimates.
Those resources, along with funds freed up by reducing the banks' loan portfolios, were "substantially consumed" by a combination of buying government bonds, repaying old debts and the disappearance of roughly €65 billion of customer deposits, UBS analysts reckon.
That leaves about €21 billion in funds, according to UBS—or less than half of what Spain needs to borrow over the remainder of 2012.
Italian banks are in a similar situation, having burned through most of what they borrowed from the ECB, according to multiple analyst estimates.
The Italian government this year still needs to issue approximately €150 billion of bonds.
The banks' dwindling cash piles and the return of market turbulence has some experts, such as Citigroup chief economist Willem Buiter, predicting the ECB will be forced to make another round of loans later this year.
That is something the central bank's German faction is reluctant to do.
ECB hawks, especially the German contingent, are very wary of the inflationary impact of the program and already are pushing for the formulation of an exit plan.
wsj.com
The European Central Bank's roughly €1 trillion ($1.31 trillion) of emergency loans caused interest rates of troubled euro-zone countries to plummet earlier this year, easing fears about Europe's debt crisis. But lately rates have again been marching higher.
One big reason: After months of using that cash to buy their government's debt, banks in Spain and Italy have little left, say analysts and other experts.
The banks' voracious buying had helped bring down the interest rates, providing relief for troubled countries that need to issue tens of billions of euros of bonds this year.
But the banks, lately the primary buyers of Spanish and Italian government bonds, no longer have much spare cash to continue such purchases.
That is sending rates back up, rekindling investor fears about Europe's ability to arrest the three-year-old sovereign-debt crisis and return the region to health.
The ECB had handed out the emergency three-year loans to at least 800 banks in two helpings, one in December and the other in February.
Banks used a big chunk of the money to snap up their governments' bonds, spurring sighs of relief from global markets.
The current strength of the ECB's rescue mission may be tested Thursday, when Spain, one of the euro zone's most troubled economies, auctions €2.5 billion of its bonds.
Despite a surprisingly strong sale of treasury bills on Tuesday, some experts worry that Spanish banks could be less active this time around, leaving Spain stuck with lackluster demand for its debt.That adds to worries that one of Europe's biggest economies might eventually need to seek financial aid from the international community.
"Eventually the liquidity extended [by the ECB] will be fully deployed, and at that point Spanish and Italian banks will either have to stop buying sovereign bonds, removing the largest buyer from the sovereign market, or sell bonds" to raise cash for their own needs, said Alan Broughton, an analyst at RBC Capital Markets.
The chief purpose of the ECB bailout was to keep the banks themselves well-funded. They have tens of billions of euros of their own debt coming due this year.
In that sense, the loans have succeeded: They have greatly reduced the risk that a European bank will suddenly run out of money and become an albatross around the neck of a weak country.
But the ECB's Long-Term Refinancing Operations, or LTROs, had a broader purpose: to get more money out into the wider economy, and especially to finance governments that had trouble borrowing on their own.
The cash "means that each state can turn to its banks, which will have liquidity at their disposal," French President Nicolas Sarkozy said in December, just after the first LTRO was announced.
In financial circles, the practice of banks' borrowing from the ECB in order to lend to their governments was dubbed the "Sarkozy carry trade."
In early March, ECB President Mario Draghi called the LTROs an "unquestionable success." Banks, he said, are having an easier time funding themselves, and international investors are tiptoeing back in.
"Certainly, we see many signs of a return of confidence in the euro," he said, adding that the loans offered European governments breathing room to get their fiscal houses in order.
European stock and bond markets stormed ahead in the first quarter, a sign of greater desire for riskier assets. By mid- March, European bank shares had rallied as much as 15% from the start of the year.
Bond yields in fiscally troubled European countries tumbled, a sign of waning investor fear, with Spain's 10-year bonds dropping from about 7% last November to below 5% in early March.
Weeks later, that confidence has ebbed.
Despite the new money sloshing around Europe, the fundamentals of the debt crisis are little changed: Spain and Italy both need sustained access to financing to cover their deficits.
If foreigners stay away and local banks run out of firepower, both countries will be back where they started before the LTRO.
A growing array of analysts and others worry that the flood of ECB loans in some ways could be counterproductive. The cheap money has reduced the urgency with which some banks are cleaning up their balance sheets, a trend that some critics worry could delay the industry's return to health.
Banks counter that what some see as foot-dragging is simply their trying to avoid a chaotic deleveraging process that could hurt the European economy.
"The market has been treating the LTRO as a panacea," said James Ferguson, head of strategy at Westhouse Securities in London. "It's absolutely better than what would have happened without it, but that doesn't mean it's a fix."
In theory, lending the local banks money they could in turn lend to the government at a profit buys time for the governments to enact overhauls that can lure back foreign investors.
That is essential: Both the Spanish and Italian economies run deficits with the rest of the world; their businesses and citizens don't generate enough surpluses on their own to finance the government.
But enticing foreigners has proved hard. Spain has relaxed its fiscal targets amid worries about the effect of austerity on its economy, and the International Monetary Fund projected Tuesday that Italy wouldn't meet its 2012 deficit target.
Data from Spain and Italy suggest local banks bought the bulk of the governments' new debt, and picked up a chunk of what foreigners were selling.
In Italy, domestic banks increased their holdings of Italian government debt by 29% in the three-month period ended February 2012, which includes the first of the ECB's two cash injections but not the second.
In Spain, banks took about €200 billion in ECB loans, according to analyst estimates.
Those resources, along with funds freed up by reducing the banks' loan portfolios, were "substantially consumed" by a combination of buying government bonds, repaying old debts and the disappearance of roughly €65 billion of customer deposits, UBS analysts reckon.
That leaves about €21 billion in funds, according to UBS—or less than half of what Spain needs to borrow over the remainder of 2012.
Italian banks are in a similar situation, having burned through most of what they borrowed from the ECB, according to multiple analyst estimates.
The Italian government this year still needs to issue approximately €150 billion of bonds.
The banks' dwindling cash piles and the return of market turbulence has some experts, such as Citigroup chief economist Willem Buiter, predicting the ECB will be forced to make another round of loans later this year.
That is something the central bank's German faction is reluctant to do.
ECB hawks, especially the German contingent, are very wary of the inflationary impact of the program and already are pushing for the formulation of an exit plan.
wsj.com
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