21/12/2011 08:13 GMT | Updated 21/12/2011 08:25 GMT

Eurozone Crisis: ECB's 'Back Door Quantitative Easing' Lifts Markets

A new lending programme from the European Central Bank has been hailed as quantitative easing by the back door, causing markets to rally on fresh hopes that a solution to the eurozone debt crisis might be on the cards. However, concerns began to bleed back in by early afternoon.

More than 500 banks borrowed €489bn from the ECB on Wednesday as a programme of cheap three-year loans offered by the institution saw strong demand. Initial consensus expectations were that take-up would be in the region of €300bn.

The initiative, which allows banks within the eurozone to borrow at massively reduced rates of 1%, aims to ease the funding pressure within the single currency area and head off a credit crunch. The move has also potentially resolved some of the short-term concerns over the Spanish economy, which has been suffering from a major dearth of confidence due to its under-capitalised banking sector.

While this is not the ECB "bazooka" - money printing to buy Italian, Spanish and other eurozone countries' debt - that many in the markets had hoped for, analysts noted that the programme can operate as quantitative easing through the back door, with banks able to borrow money cheaply to buy bonds.

As many analysts noted, there is a profitable "carry trade" to be made in borrowing at 1% from the ECB and buying up peripheral debt at 5% or more, especially given that some of the risk has been taken out by EU promises that private sector holders will not face "haircuts" on their holdings in the event of any future debt restructuring.

Markets have rallied on the apparent success of the programme. The German DAX and French CAC-40 closed up 3.11% and 2.73%, respectively, on Tuesday, and extended those gains in early trading on Wednesday, although the rally began to peter out by early afternoon.

"It's still not as good in my view… as the ECB buying bonds directly, and we'd maintain the view that it's not going to have the full effect that they're hoping for," John Ventre, a portfolio manager at Skandia Investment Group said. "But in terms of putting a credit crunch in Europe further away, taking some of that risk away, it certainly does that."

Perhaps more significantly, an auction of short-term Spanish debt saw yields fall markedly on Tuesday, as investors took heart from what looked to be a potential - temporary - solution to the banking crisis in the country.

Spain's sovereign debt has been under pressure because of widespread fears that it would have to bail out its banks, massively adding to a debt mountain that is, by Italian standards at least, relatively modest.

The Spanish government's debt is only around 60% of its gross domestic product (GDP), but the collapse of the country's housing bubble left many of its regional savings banks, or cajas, hugely underfunded and fragile to external shocks. Despite being semi-nationalised and compelled to merge, those banks have struggled to raise money to increase their resilience. The ECB's programme should allow them to begin to build their capital relatively cheaply, easing the pressure on the sovereign.

"If ECB action can sort out the banks, then this takes Spain off the hit list," Ventre said.

Some analysts, however, suggested that the rally was driven by liquidity, rather than a real belief that the ECB had meaningfully changed the dynamics of the sovereign debt crisis.

“The big figure was welcomed initially but huge demand for ECB loans is not exactly a positive and simply reflects the huge squeeze European banks are feeling at present," Richard Driver, analyst at Caxton FX said. “The loans taken up will certainly help to ease liquidity, similar to last month’s coordinated central bank action on dollar swaps, but it also highlights the gravity of the situation in the eurozone."

Italy remains the biggest worry for the eurozone - its debt stands at €1.8tr, around 120% of its GDP, and there are serious doubts about its ability to cut back on government spending. Those concerns have led to a rise in its cost of borrowing, with yields on 10-year bonds crossing the 7% mark in November. The country has to refinance hundreds of billions of euros in debt over the next few years, and, with growth forecast to be sluggish at best, faces serious challenges to its solvency.

European Union leaders failed on Tuesday to agree on how contributions to a proposed €200bn loan to the International Monetary Fund would be split between member states. Bolstering the IMF's lending facility is one way that policymakers might be able to make the resources available for any future rescue of the eurozone's struggling economies.

Plans to source money from emerging markets to boost the European Financial Stability Facility (EFSF) have already fallen by the wayside, and Germany has nixed proposals for centrally-issued "eurobonds", on fears that its own jealously-guarded sovereign rating would be jeopardised.

Market participants routinely talk about the need for a €1tr firewall to protect the eurozone in the event of Italy becoming insolvent and needing a bail out, although how that figure is affected by the fact that some banks have now been able to start their recapitalisation process using ECB money remains to be seen.

"There's a bit of light in it, there's a bit of dark in it," Ventre said. "The dark is it probably doesn't achieve exactly what the ECB is hoping for, but the light of it is that it goes some way towards stabilising the European financial system, if not the European sovereigns."