Trichet May Start ECB’s Second Run at Exit Strategy (Update1)

By Gabi Thesing
Aug. 5 (Bloomberg) -- European Central Bank President Jean- Claude Trichet may be starting his second run at an exit strategy.
As the euro-area economy gathers strength and the region’s bond markets show signs of stabilizing, the ECB is running down the emergency bond purchases it introduced in May to fight the sovereign debt crisis. The challenge for Trichet is to signpost how the ECB will scale back the supply of unlimited cash to banks without throttling the recovery or roiling investors.
The euro has rebounded 10 percent since June and stocks have jumped as the market turmoil that in May threatened to splinter the currency eases. While economists say Trichet is unlikely to outline his plans until next month, an improving economy and the confidence boost given the banking system by European Union stress tests may prompt officials meeting in Frankfurt today to discuss laying the groundwork for the exit.
"All this is likely to have pushed the ECB toward returning to its exit strategy," said Klaus Baader, co-chief European economist at Societe Generale SA in London. "They will proceed carefully but for the remainder of the year the bank will progressively wean the banks off cheap cash."
Europe’s Stoxx 600 Index has gained almost 11 percent in the past month and the gap between Spanish 10-year government bonds and German debt of the same maturity has narrowed to 154 basis points after touching a euro-era high of 221 on June 16.

Abandon

The ECB’s 22-member governing council will set the benchmark lending rate at 1 percent for a 16th month, according to all 51 economists in a Bloomberg News survey. The announcement is due at 1:45 p.m. and Trichet holds a press conference 45 minutes later. The ECB will not raise its key rate until the third quarter of 2011, a separate survey showed.
Policy makers in May abandoned the withdrawal of the emergency measures introduced to fight the global recession as Greece’s debt crisis spread through Europe. The euro dropped 15 percent in the first half of the year and the premiums investors charge to hold Greek, Spanish and Portuguese debt over bunds soared to euro-era records.
The euro slipped 0.1 percent to $1.3145 as of 9:41 a.m. in London. That compares with a four-year low of $1.1877 on June 7.

‘Steady Rise’

The ECB now has to decide how to wind down its non-standard measures, which currently gives banks unlimited liquidity for periods of up to three months at its benchmark rate.
Banks can borrow as much money as they need for seven days and one month until at least Oct. 12. It has committed to offering such cash for three months until September after the Greek crisis in May forced the ECB to retreat from a plan to reintroduce an auction procedure. The ECB last year scaled back
12 and 6-month loans introduced to fight the global slump.
Investors’ expectation that unlimited liquidity offerings will be withdrawn is already "fuelling the steady rise" in interbank lending rates, said Matteo Regesta, a strategist at BNP Paribas in London. The rate that European banks charge each other for three-month loans in euros has risen 20 basis points since the end of May, climbing to a one-year high of 0.9 yesterday.

Too Soon

The ECB has already reined in its bond buying, which split the Governing Council when it was started at the depth of the crisis in May. Purchases dropped to 81 million euros last week from 16.5 billion in the first week, bringing the total to 60.5 billion euros.
"The ECB has effectively ended that program," said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. While "it’s too early to resume the exit strategy at this stage, Trichet will certainly say that developments in the economy and financial markets are going in the right direction. It’s not often the ECB has been in that position lately."
The risk for the ECB is that they tighten policy too soon just as government austerity measures to reduce budget deficits threaten growth.
Spanish unemployment rose to 20.1 percent in the second quarter, the highest in more than a decade, and export prospects were hurt when manufacturing growth in China slowed last month.
The ECB said July 28 that European banks continued to tighten credit standards in the second quarter.

‘Nervous’

Peter Westaway, chief European economist at Nomura International Plc in London, said he expects the ECB to continue its full-allotment policy until mid-2011, though it may shorten the maturities.
"Markets remain nervous and the ECB wants to ensure that the liquidity withdrawal occurs gradually and without major surprises," he said.
For now, the economy is picking up. Growth in Europe’s services and manufacturing industries accelerated in July, while business confidence in Germany soared. Loans to households and companies grew at the fastest pace in 20 months in June.
Schneider Electric SA, the world’s biggest maker of circuit breakers, on July 30 raised its 2010 profitability target and Bayerische Motoren Werke AG, the world’s largest maker of luxury cars, in Aug. 4 reported its biggest profit in 2 1/2 years.
In a further sign that the ECB wants to revert to pre- crisis operations, it introduced tougher premiums on the assets it accepts against loans and on June 30 said it had completed its year-long covered-bond purchase program.
"It’s a bit like groundhog day," said Juergen Michels, chief euro-area economist at Citigroup Inc. in London. "They’re keen to get back on the pre-crisis exit path and the pressure is building to announce something in September."