ECB boosts capital; EU leaders set crisis fund

The European Central Bank moved to increase its financial firepower to fight the euro zone debt crisis on Thursday, and European Union leaders agreed to change the EU treaty to create a permanent crisis resolution system.

The ECB, in charge of monetary policy in the 16-nation euro area, said it would almost double its capital to 10.76 billion euros to cope with bigger credit risk and market volatility. Euro zone members will provide the increase.

IMF Managing Director Dominique Strauss-Kahn, who has been critical of EU leaders' slow and piecemeal response to the rolling crisis, said he was worried about slow growth and the threat of contagion in Europe.

The bad news as you say is coming from Europe, where the recovery is really sluggish and where growth is the main problem to face, Strauss-Kahn told a Thomson Reuters Newsmaker event.

EU leaders approved a two-sentence amendment to the EU's governing treaty at Germany's behest to permit the creation of a permanent European Stability Mechanism for handling financial crises from 2013, a draft summit statement said.

The ESM, to replace a temporary financial safety net created in May, will be empowered to grant loans on strict conditions to member states in distress, with private sector bondholders sharing the cost of any debt writedown on a case-by-case basis.

The aim is to have the treaty change ratified by all member states by end 2012. Decisions will be taken by unanimity, ensuring that EU paymaster Germany retains a veto.

The leaders were also to discuss current crisis management efforts, including a possible increase in available rescue funds, but were not expected to take a decision this week.

The EU, together with the IMF, has set up a 750 billion euro ($1 trillion) emergency loan fund to provide assistance to highly indebted euro zone states that are unable to finance themselves in volatile financial markets.

The 27 leaders were holding their seventh summit of the year, a record number due to the rolling debt crisis, in which Greece and Ireland have received EU/IMF bailouts and Portugal and Spain are seen by markets as potential risks.

The decision by the Frankfurt-based ECB to raise its subscribed capital base was the first such increase in its 12-year lifetime, a mark of the severity of the situation.

We infer from this that the ECB ... is seeking a greater cushion in order to offset potential losses, given that its portfolio of securities holdings has risen substantially, as well as to protect itself from potential collateral losses, Barclays Capital economists said in a research note.

The central bank has bought some 72 billion euros in euro zone government bonds since May but has resisted political pressure to substantially step up these asset purchases to help indebted governments avoid having to seek a bailout.

SEVENTH CRISIS SUMMIT

The two-day EU summit began with Portugal and Spain facing growing bond market pressure and calls to overhaul their public finances and economies to improve competitiveness.

Credit ratings agency Moody's highlighted investor fears about the first country to receive an EU/IMF rescue by saying it was putting Greece under review for a possible downgrade, due to uncertainty over its ability to cut debt to a sustainable level.

Strauss-Kahn told Reuters he was concerned about the length of the process Europe was going through to resolve its crisis and said the EU needed to find a comprehensive solution.

While she pressed for a treaty change to assuage Germany's constitutional court, Chancellor Angela Merkel sought to keep other ideas, such as increasing the size of the current rescue fund or issuing euro zone bonds, off the summit agenda.

Merkel told reporters that setting up the permanent stability mechanism was a giant act of solidarity and reaffirmed Germany's commitment to a stable, enduring euro.

The chancellor said earlier she had settled a dispute with Jean-Claude Juncker, who chairs the finance ministers of the euro zone, over his call to issue common euro area bonds, but differences still looked likely to arise at the summit.

Jean-Claude Juncker and I had a long telephone conversation and cleared up the issue a while ago, Merkel said in an interview with Germany's Bild newspaper published on Thursday. With so much at stake, the emotions sometimes get involved.

The head of the European Parliament, Jerzy Buzek, told leaders at the summit that euro bonds should not be dismissed.

Merkel contends so-called E-bonds would remove the incentive for countries to balance their budgets, and would raise Berlin's borrowing costs. Juncker, who last week called Germany's instant rejection un-European, confirmed he had made peace with Merkel but hinted he might raise the proposal at the summit anyway.

I know very well that if there is a debate (on euro bonds), there cannot be a decision one way or the other at today's European summit, Juncker told French daily Liberation, vaunting the benefits of common bonds for reinforcing fiscal discipline.

Ratings agency Moody's warned Spain on Wednesday that its debt could be downgraded, saying it was worried by big central government funding needs, indebted banks and regional finances.

Spain's Treasury paid a high premium to sell long-term bonds on Thursday but found strong demand, in a test of investors' appetite for euro zone peripheral debt.

Portugal announced extra measures on Wednesday to cut red tape and bolster structurally slow growth, in a move to convince EU officials and financial markets it is doing enough to stave off the pressure to seek EU financial aid.

Throughout 2010, EU leaders have struggled to show unity and clear communication in handling the crisis, alternating between rushing out half-formed or contradictory proposals and dithering on the right course of action while markets burned.

There has been a relative lull in financial market pressure in the past two weeks as investors and traders close their books ahead of the end of the year, but analysts expect pressure to resume in 2011 without action.

Belgian Finance Minister Didier Reynders said the EU's portion of the existing crisis fund, totaling 440 billion euros, could potentially be doubled to fend off the threat of renewed market pressure on Portugal and Spain.

Of course we need to show we have deep pockets, Reynders told reporters.