Monti meets German resistance over bond-buying plan

Optimism surrounding a suggestion by Italy that the eurozone should introduce a mechanism to reduce borrowing costs quickly died down in the face of German intransigence

As Spain and Italy's debt financing costs peak yet again, European Union leaders have been discussing a mechanism to reduce the spreads between eurozone sovereign yields when they widen beyond an alarming level. The proposal came from the Italian government, emphasising again the creativity shown by Prime Minister Mario Monti's technocratic administration in recent months.

In a briefing with journalists in Brussels last Monday, Enzo Moavero, Italy's European affairs minister and Monti's closest aide, launched the idea of "an automatic mechanism" that could buy the sovereign bonds of eurozone countries under strain to reduce their borrowing costs. He said that bond-buying operations could be conducted by the European Central Bank, by one of the EU rescue funds or "by other financial institutions".

The ECB has already carried out two huge injections of liquidity into the eurozone in November and February, pumping around €1 trillion into the financial system through short-term loans to banks with low interest rates. The tacit deal was for banks to partly use the money to buy sovereigns – which they did, temporarily easing borrowing costs in the peripheral countries.

Despite the huge sums put into the system, the measures failed to calm the markets for long. This has also been the case for attempts that have followed since. The €100bn aid plan promised by the eurozone to rescue Spain's banking system at the beginning of June has so far failed to convince investors of Madrid's solvency, as the country faces up to the bursting of a huge housing bubble.

Italy, too, remains dangerously burdened with one of the highest public debts in the world, at around 120 per cent of its gross domestic product. Hence Italy's new plan to curtail the problem. "Under the new scheme, the ECB could repeat what has already been done, but in a semi-automatic way," Moavero suggested, hinting at the possibility for the Frankfurt bank to buy bonds of stressed states every time it is deemed necessary.

The idea was floated as world leaders were meeting in Los Cabos, Mexico, for the G20. On Tuesday, Monti confirmed the plan but spoke of the possible use of the EU rescue funds to purchase bonds, rather than involving the ECB. The initial reaction seemed to be positive. "Italy has launched an idea which is worth looking at," France's President François Hollande said.

And in an interview with the Financial Times, ECB executive board member Benoit Cœuré suggested that the EU's temporary bail-out fund, the European Financial Stability Facility, could buy bonds. He underlined that the EFSF is already allowed to conduct financial operations in the secondary market. "It's a mystery why ... governments have not yet chosen to use that possibility," he said.

But the positivity created by the suggestion did last long. Showing no deviation from her previous position, German Chancellor Angela Merkel played down the idea. Her finance minister, Wolfgang Schaeuble, went on to criticise public statements that risk encouraging false speculation. "There are different types of instruments that we can use efficiently, but we don't need continuously new considerations in public," he said on arrival at a meeting of eurozone finance ministers yesterday in Luxembourg.

Showing little diplomacy, the European Commission made an even harsher comment. Its economic affairs spokesperson Amadeu Altafaj called any mechanism aimed at keeping bond yields in check "financial paracetamol", meaning that it would be unable to calm markets for a meaningful period of time.

Yesterday, eurozone finance ministers in Luxembourg discussed the Greek conundrum and the imminent Spanish request for aid, which it is expected to be for around €60bn according to auditors' estimations, out of the €100bn made available by euro area partners. The bond purchasing plan was not officially in the agenda.

What is missing is a political deal, since instruments are already in place to effectively reduce the spreads. As the ECB's Benoit Cœuré explained, the EFSF and its enhanced and permanent replacement, the European Stability Mechanism, could already buy bonds – but only under certain conditions.

"Under the EFSF treaty, buying bonds would be equal to an aid programme and would therefore require the respect of specific conditions," explained a European diplomat. This is exactly what Italy does not want. Ending up with the kind of draconian requirements that Greece, Ireland and Portugal are suffering is the last thing the Italian government wants. "Italy is asking for help without conditions", a second diplomat commented.

Moreover, given the limited capacity of the EFSF and the ESM, with at most €500bn available, a potential programme to purchase bonds would only be effective if the funds had a banking license enabling them to borrow from the ECB. Since Germany firmly opposes this idea, the so-called financial paracetamol will not help to relieve any of the pain in the European economy. Indeed it seems certain that, far from providing a cure, the continued postponement of such decisions could kill the patient.