ECB chief Jean-Claude TrichetJOHANNES EISELE
As its sovereign bond spreads hit new records, making it punitively expensive to obtain new financing through normal channels, Portugal is under fierce pressure to bow to the inevitable and take a bailout orchestrated by the European Union and the IMF.
The interest-rate premium demanded in the bond market dropped on Monday after the European Central Bank intervened and bought up Portuguese bonds on the secondary market.
But the ECB is running out of Band-aids and fast losing what little credibility it has left by playing what some analysts call "the extend and pretend" game.
The central bank, whose very survival depends on a successful defence of the embattled euro zone, has been buying up large quantities of sovereign bonds since last year.
By mid-December, it held €72-billion worth of Greek, Irish and Portuguese debt. But it is on the hook for much larger amounts, held as collateral in exchange for funnelling cheap funding (about 1 per cent interest) to desperate banks in the three countries, as well as Spain.
It has been a wonderful closed circle. The banks would buy up new debt issued by the deficit-ridden governments, which would pronounce their bond auctions a huge success. These bonds would then be used to secure funding from the ECB that would keep the banks afloat - and even enable them to make a tidy profit on the difference between the interest on the government bonds and the ECB financing - thus saving governments from dealing with the fallout of soaring financing costs and massive bank failures.
As noted risk analyst Satyajit Das points out, this strategy "assumed that the problem was temporary liquidity, not solvency. The solution was to ensure that the troubled countries could continue to finance. The restoration of confidence would enable a rapid return to market financing and the status quo."
But the problem is indeed one of solvency. The ECB could further boost its bond-buying or provide the capital for the banks to do so. If financial market conditions continue to deteriorate, the ECB could make like the Federal Reserve and print money - provided its governing rules are changed.
But this would do nothing to boost confidence in the euro or in the ECB's ability to maintain an independent monetary policy.
"Extend and pretend" refinancing measures of the sort being pursued within the EU "would allow orderly default or debt restructuring by some countries over time," Mr. Das says. "It minimizes losses, controlling the timing and form of restructuring. It would also minimize disruption to financial markets and solvency issues for investors and banks with large exposures."
But there can be no doubt that defaults and restructurings are coming.