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Fri Dec 16, 2011, 02:32 PM


ECB is playing a dangerous game


Strange to report, but euroland has had a good few days if progress is measured by bond prices. Yields are down across the board; the spread between French and German yields is closing; and Spanish 10-year yields stand at 5.2%, which is almost respectable by the standard of recent months.

This outbreak of mild optimism has nothing to do with the French establishment's bizarre decision to throw insults at the UK. Nor is it related to last week's EU summit, which left the eurozone countries miles away from debt-sharing, or even co-ordinated measures to promote growth. No, yields appear to be falling because the European Central Bank is prepared to inject massive quantities of liquidity into the eurozone banking system. Call it the miracle of the long-term refinancing operations, or LTRO.

Unfortunately, this miracle may not be a miracle; it may be too good to be true. Here's how LTRO works: eurozone banks can turn up at ECB and borrow at 1% for three years by pledging as collateral assets that can be almost anything from government bonds to loans to small businesses. The ECB is being hugely generous in its relaxation of standards. "They're not just taking luncheon vouchers, they're taking loans to the luncheon voucher companies," comments Nick Parsons, strategist at National Australia Bank.

Eurozone banks could be forgiven for sniffing a bargain. A bank can borrow at 1% to buy Italian bonds yielding 6%-plus; it can then pledge those bonds as collateral to borrow some more money at 1% and repeat the trick. The scheme could turn out to be a guaranteed way to drum up demand for sovereign bonds, which is why yields are falling. But it is hard to say it is wise policy on the part of the ECB.

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