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Trichet Faces Market Rate Threat as Debt Crisis Hurts Growth

European Central Bank President Jean- Claude Trichet is facing higher interest rates sooner than he may have planned.

Interbank borrowing costs have been climbing since financial institutions had to pay back a record 442 billion-euro ($557 billion) ECB loan on July 1, threatening to hurt the economy just as investors fret about the health of the banking system and the ongoing sovereign debt crisis. That may force the ECB to consider additional lending measures when policy makers convene in Frankfurt today, economists and analysts said.

“The question Trichet will have to answer is whether the ECB will tolerate higher market rates at this point in time,” said Christoph Rieger, an interest-rate strategist at Commerzbank AG in Frankfurt. “It’s questionable whether these rates are appropriate now.”

The increase in funding costs comes as Europe’s economy shows signs of weakening after Greece’s fiscal crisis undermined investor confidence, forcing governments to cut spending and conduct stress tests on banks to prove their resilience. The ECB has embarked on an unprecedented program of bond purchases in an effort to contain rising yields in debt-strapped countries, and has reintroduced some of the non-standard measures it employed during last year’s financial crisis, such as unlimited longer- term lending to banks.

Record-Low Benchmark

All 55 economists in a Bloomberg News survey expect the ECB to leave its benchmark rate at a record low of 1 percent today. The announcement is due at 1:45 p.m. in Frankfurt and Trichet holds a press conference 45 minutes later.

Market rates are rising after the expiry of the landmark 12-month loan this month, and lower-than-expected take-up of shorter-term ECB loans, reduced excess liquidity in the system.

The European Overnight Index Average rate, or EONIA, jumped to 0.542 percent on June 30 from as low as 0.295 percent on June 3. The rate that banks charge each other to borrow for three months has increased to 0.8 percent, the highest in 10 months, from 0.63 percent at the end of March.

“Less liquidity in the system is leading to a significant increase in money-market rates that in pre-crisis times could only be achieved with an interest-rate hike,” said Juergen Michels, chief euro-area economist at Citigroup Inc. in London. He predicts the overnight rate will increase to 0.8 percent by October.

Positive Sign?

The ECB, which no longer offers banks 12-month loans, could look at a new six-month offering in an effort to boost liquidity and damp market rates, according to Citigroup and Commerzbank. The ECB has already committed itself to another three unlimited three-month loans fixed at its benchmark rate.

Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London, said the ECB may view the reduced demand for its loans in recent offerings as a positive sign that banks are less dependent on its funds and prepared to borrow on the market instead.

“The ECB will wait at least until the bank stress tests are published to see whether there will be a negative shock on funding costs out of that,” he said.

European Union leaders pledged on June 17 to disclose the results of the stress tests by the end of July, showing how individual banks would hold up to economic and market shocks.


The sovereign debt crisis triggered a rout in Greek, Portuguese and Spanish bonds. European lenders had $2.29 trillion at risk in Greece, Italy, Portugal and Spain at the end of 2009, including loans to governments, according to the Bank for International Settlements.

Greek, Irish and Portuguese banks are the most reliant on ECB funding, Barclays Capital analyst Simon Samuels wrote in a note to clients on June 29.

Higher rates are “certainly causing the Greek, Spanish, Portuguese and Irish Governing Council members some headaches because it helps prolong their banks’ dependence on ECB money,” said Carsten Brzeski, an economist at ING Group in Brussels. “On the other hand, I don’t think the Germans will be too bothered.”

The ECB’s non-standard measures have already divided the 22-member Governing Council, with the most recent decision to buy government bonds drawing criticism from Germany’s Axel Weber and ECB Executive Board member Juergen Stark.

The ECB “can do more,” said Paul Donovan, deputy head of global economics at UBS AG in London. “The question is whether they choose to do so with sufficient enough unanimity to reassure the markets.”