ECB To Drain Cash In Offset To New Yield-capping Scheme -sources

The European Central Bank will likely drain cash from the banking system to offset any bond purchases made to cap borrowing costs for indebted euro zone states, two sources told Reuters.

Bond yields for Italy and other debt-laden countries have surged since the ECB unveiled plans to stop buying debt and raise its interest rates for the first time in over a decade next month to fight runaway inflation.

The market turmoil has forced the ECB to speed up work on a new bond-buying scheme to curb yields. This leaves it in the difficult position of raising borrowing costs for the euro zone as a whole, while at the same time capping them for some of its weaker members.

To avoid this apparent contradiction, the ECB is considering pairing the new bond-purchase scheme with auctions at which banks can park cash at the ECB for a more favourable interest rate than the ordinary rate on deposits, the sources with direct knowledge of the matter said.

This would allow the ECB to 'sterilise' the bond purchases under the new scheme, in a repeat of its weekly "liquidity-absorbing" operations of a decade ago. These offered banks an interest rate up to that of the ECB's refinancing operation, then 0.25%.

An ECB spokeswoman declined to comment.

Unlike a decade ago, the ECB has created 4.48 trillion euros ($4.74 trillion) of excess reserves in the banking system via a plethora of stimulus over the past decade, creating ample room for manoeuvre.

The planned solution would also be more convenient than selling bonds from countries where borrowing costs are lower, such as Germany, as this would likely cause losses for the local central bank.

Bank of Italy governor Ignazio Visco alluded to such a move earlier this month, when he said the ECB did not need to sell bonds to sterilise its purchases and could work with interest rates instead.

The new scheme, aimed at fighting financial fragmentation between euro zone countries, will be unveiled at the ECB's Governing Council meeting of July 21.

Details are still being ironed out but it should come with loose strings attached for beneficiary countries, such as a requirement that they comply with the European Commission's economic recommendations.

ECB policymakers are gathering in Sintra, Portugal, this week for their annual forum.

($1 = 0.9449 euros)