In the midst of the crisis with sovereign debt of Greece, Spain, and Portugal, Trichet and the ECB acted by offering as much cash as the countries needed. This stabilized things for a while and Trichet was supposed to drop this support.

However, yield spreads between Germany and the PIIGS is once again soaring, and if unlimited lending is withdrawn now, it is a near-certainty that spreads will widen further.

Thus Trichet is ‘Trapped’ by Banks’ Addiction to ECB Cash.

Near-record borrowing costs for nations across the euro region’s periphery are making it harder for the ECB to wean commercial banks off the lifeline it introduced two years. The extra yield that investors demand to hold Irish and Portuguese debt over Germany’s rose last week to 454 basis points and 441 basis points respectively. Spain’s spread hit a two-month high.

The risk for the ECB is that it gets pulled deeper into helping the banking systems of the most indebted nations in the 16-member euro bloc. Governing Council member Ewald Nowotny said Sept. 6 that addiction to ECB liquidity is “a problem” that “needs to be tackled.” Complicating the ECB’s task is that interbank lending rates have risen, tightening credit conditions and making access to market funding more expensive for banks.

“The ECB is trapped and the exit door is blocked,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. “The state of credit markets is going to force them to stay in crisis mode for longer than some of them would like.”

Irish 10-year bond yields soared to a record on Sept. 29 on concern the bailouts of Anglo Irish Bank Corp. and Allied Irish Banks Plc. would overwhelm government finances. The Portuguese- German 10-year yield spread, which hit a record on Sept. 28, was at 398 basis points yesterday, up from 88 basis points on March 10.

While it has phased out its 12- and 6-month loans, the central bank still lends unlimited amounts in its weekly, monthly and three-month tenders. In May, it was forced to reintroduce the unlimited three-month loans and start buying government bonds as Europe’s deepening debt crisis started to threaten the survival of the euro.

With the ECB unlikely to match other nations’ “expansive monetary policy measures,” the euro may continue to strengthen, crimping the region’s exports and economic expansion, economists at WestLB AG economists said in a research note. The single currency has gained 16 percent against the dollar in the past four months and touched $1.3941 yesterday, the highest since February.

Currency Tensions Build

With the rise in the Euro vs. the US dollar, the Euro is also rising vs the Yuan given the Yuan’s peg to the dollar.

Trichet and the EU are pissed that the Euro, and not the Yuan is at the center of global currency trends. Japan is also upset to the point of currency intervention.

China Tells EU to Stuff It

In the midst of global currency debasement wars, China Hardens Opposition Over Yuan Gains, Tells EU to Back Off

China stiffened its opposition to a rapid appreciation of the yuan, setting the stage for a confrontation over exchange rates at this week’s international monetary meetings in Washington.

Premier Wen Jiabao said China will stick to its policy of gradually increasing the currency’s flexibility and lashed out at European Union leaders for teaming with the U.S. to pressure the Chinese government.

“Europe shouldn’t join the choir” clamoring for a higher yuan, Wen told a business conference yesterday before an EU- China summit in Brussels. “If the yuan isn’t stable, it will bring disaster to China and the world. If we increase the yuan by 20-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil.”

International exchange-rate diplomacy shifts into high gear at the Oct. 8 Group of Seven meeting in Washington after China rebuffed EU and U.S. pleas, the Bank of Japan sought to drive down the yen by unexpectedly easing monetary policy, and Brazilian Finance Minister Guido Mantega warned of a global “currency war.”

“There’s a game of brinksmanship being played,” David Cohen, an economist at Action Economics in Singapore, said in a Bloomberg Television interview. “I suspect at the end of the day the Chinese will agree to return to gradual appreciation of their currency.”

Mistake To Assume Anything

While it’s crystal clear a game is underway, it’s debatable whether that game is better called “brinksmanship” or “currency wars”. Furthermore, it’s a mistake to assume China will agree to anything.

Every country wants a weaker currency to stimulate exports, but that is physically impossible, except of course against gold. The irony is rising gold prices will not stimulate anything that central banks want, but global competitive currency debasement sure has stimulated the price of gold and silver.

Mike “Mish” Shedlock
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