Draghi Says Weapons Working After ECB Postpones ‘Armageddon’

European Central Bank President Mario Draghi says his strategy for battling Europe’s debt crisis is starting to work.

The ECB’s massive injection of cash into the financial system last month is beginning to lubricate seized credit markets and there are “tentative signs” of economic stabilization in the euro area, Draghi said in Frankfurt yesterday. While “substantial downside risks” remain, he pointed to falling yields on Italian and Spanish debt this week.

That may mitigate the need for further interest rate cuts in the short term and muffle calls for the ECB to step up its government bond purchases. While the 17-nation euro region is still in danger of sliding into recession after the debt crisis spread to Italy and Spain, driving up borrowing costs and hurting the export markets of stronger economies such as Germany, recent data suggest the worst may be over.

“The ECB can be rightly justified in saying that the Armageddon we were facing toward the end of last year does seem to have been addressed,” said James Nixon, chief European economist at Societe Generale SA in London. “Further rate cuts will only be forthcoming if, for example, we see signs of an outright credit crunch.”

The euro climbed more than a cent after Draghi spoke and traded at $1.2814 at 11:40 a.m. in Frankfurt today. The ECB yesterday held its benchmark rate at a record low of 1 percent after two straight reductions, as predicted by 47 of 53 economists in a Bloomberg News survey.

‘Ready to Act’

Asked if the ECB is open to cutting rates further, Draghi said it depends on the inflation outlook. He indicated rates will remain low for an extended period.

“The monetary stance is and will remain accommodative,” Draghi said. “Uncertainty is very high. We will monitor all developments and stand ready to act.”

Signs of economic stabilization may stay the ECB’s hand for the time being.

German exports gained in November and business sentiment in France climbed from a two-year low last month. At the same time, the German statistics office said on Jan. 11 that Europe’s largest economy contracted in the fourth quarter of 2011, raising the prospect of recession.

“There are tentative signs of stabilization of economic activity at low levels,” Draghi said.

Three-Year Loans

In addition, the ECB’s three-year loans to banks, totaling a record 489 billion euros ($628 billion), are beginning to unlock markets and have prevented a “serious” credit contraction, he said.

“It was rather comforting to see that some opening of the unsecured bond market is actually taking place, but we really are at the beginning of this process,” Draghi said. “Let’s hope it will continue.”

The market for senior unsecured bonds dried up last July after European leaders insisted on private investors participating in a Greek debt write-down. In a sign confidence may be returning to the market, Rabobank Nederland last week sold 2.75 billion euros of floating-rate senior unsecured notes and 1.75 billion euros of senior unsecured bonds.

Draghi said it remains unclear whether banks will use ECB loans to buy sovereign bonds. He nevertheless noted the recent decline in yields across the euro region and the lower cost of borrowing at Italian and Spanish debt auctions yesterday.

Debt Sales

Italy yesterday sold 12 billion euros of Treasury bills, meeting its target, with the rate on the one-year bills plunging to 2.735 percent from 5.952 percent at the last auction of similar-maturity securities on Dec. 12. Spain sold 9.98 billion euros of bonds maturing in 2015 and 2016, twice its maximum target. Today Italy sold 3 billion euros of 6 percent bonds maturing in 2014, with the yield falling to 4.83 percent from 5.62 percent.

“While it’s premature to claim that the ECB’s new liquidity measures have forestalled a credit crunch, their effect is palpable in government bond markets,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy in London. “Who would have predicted in November that in January Italy would be able to sell one-year paper at 2.7 percent?”

As the debt crisis escalated in the last quarter of 2011, the ECB faced increasing calls to ramp up its government bond purchases to cap yields. Draghi and colleagues including Germany’s Jens Weidmann pushed back, urging politicians to sort out their fiscal problems while the ECB supplied funds to prevent the banking system from collapsing.

ECB ‘Prescription’

“Beyond providing generous liquidity support to banks, the ECB does not seem to be contemplating any measure to tackle tensions in sovereign debt markets more directly,” said Holger Schmieding, chief economist at Berenberg Bank in London. “If escalating tensions were to clog up the transmission channels more severely, the ECB might have to do more.”

Draghi said he expects “substantial demand” for the ECB’s second batch of three-year loans that will be awarded on Feb. 29. Banks can borrow as much as they like against collateral and the ECB has widened the pool of assets that can be used for obtaining the funds.

“The provision of liquidity and the allotment modes for refinancing operations will continue to support the euro-area banks, and thus the financing of the real economy,” Draghi said.

Economists including Marco Valli at UniCredit in Milan say ECB rates may now be on hold for the rest of the year.

“Obviously things can change very quickly and then the ECB will act,” said Ken Wattret, chief euro-area market economist at BNP Paribas in London. “But for now, its prescription is doing what it set out to do, so there is no rush to cut rates and massively step up asset purchases.”