Europe's rescue effort takes shape

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The European Central Bank, under pressure for months to backstop Europe's financial crisis, is expected to finally ramp up its rescue efforts if euro zone countries show a commitment to repairing finances and accepting a united approach to fiscal austerity.

The urgency of the ECB's message that the euro zone must get its fiscal house in order was underscored late Monday, when ratings agency Standard & Poor's warned 15 of the 17 euro zone countries, including Italy, Germany, Spain and France, that their triple-A credit ratings are at risk because of the euro zone's deepening debt crisis.

S&P cited the risk of recession, deteriorating credit conditions and "continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis."

The S&P warning came at a critical period, just days before EU leaders are set to meet and show their plan to resolve the debt crisis.

Italy, Europe's most pressing problem, earned some relief Monday a day after the country set an austerity and growth plan valued at €30-billion ($41-billion) to tackle its deficit. Investors bought Italian bonds and sent yields plunging well below their recent 7-per-cent crisis level that sank Greece, Ireland and Portugal. Yields on benchmark 10-year Italian bonds dropped about three-quarters of percentage point to just under 6 per cent, while 2-year bond yields fell even more.

ECB president Mario Draghi issued an implicit offer of help late last week when he called for a "new fiscal compact," adding tantalizingly that "other elements might follow" if the ECB got its way. The bank wants to see extraordinary fiscal discipline across Europe, to the point that the 17 euro zone countries would accept common economic management.

Mr. Draghi's comments hint "at a quid pro quo between progress on the euro zone economic governance and more pro-active support from the ECB," Deutsche Bank economists said in a note.

The Italian yield plunge came as German Chancellor Angela Merkel and French President Nicolas Sarkozy announced in a Paris mini-summit Monday that they would "force march" the euro zone into a new regime designed to ensure that individual countries would never again overspend to the point of triggering a crisis for the common currency.

The Merkel-Sarkozy plan would impose automatic sanctions on countries that breach strict budget-deficit limits; impose national debt brakes; set monthly euro zone meetings that presumably would review budgets; and launch the euro zone's permanent bailout fund, the European Stability Mechanism, in 2013, a year earlier than first planned. It would back away from the imposing deep losses, or "haircuts" on any future sovereign debt restructurings. Germany's insistence on 50-per-cent haircuts on Greek debt triggered a run on the bonds of other weak countries, notably Italy's.

Even though the move toward fiscal unity would require renegotiating European Union treaties, most of the euro zone countries are expected to approve the measures, which will set the agenda at the EU summit in Brussels on Thursday and Friday.

"I think one of the reasons Merkel is pushing for fiscal integration is that she cannot afford to have another summit flop, or the markets would destroy the euro zone," said Mike Lenhoff, chief strategist in London with investment manager Brewin Dolphin.

While the ECB made no comments Monday about the apparent willingness of euro zone countries to embrace fiscal discipline, or on Italy's suddenly plunging funding costs, there's a growing sense that progress could lead the ECB to take a more active role battling the debt crisis.

Deutsche Bank said the ECB could signal a market-lifting "pre-commitment to keep [the sovereign bond buying]program very active for at least the first half of next year," though it doubted the ECB would go so far as to announce the specific volume of bonds it would be prepared to buy.

The ECB has been buying the bonds of Italy, Spain and other highly indebted countries, but has been reluctant to accelerate the program for fear of blending fiscal and monetary policy. The German members of the ECB's top policy-making boards have been especially critical of the ECB's bond purchases.

Mr. Lenhoff agrees that the ECB "would be prepared to be more responsive to the crisis as a quid pro quo for a fiscal compact." He thinks the support could include channelling ECB funds into the International Monetary Fund, which has taken key roles in the bailouts of Greece, Ireland and Portugal and is monitoring the austerity programs announced by the Italian government.

Italy's sudden enthusiasm to get its fiscal house in order, at the insistence of the ECB, Germany and France, is behind the apparent new belief that the euro zone's third-largest country might be able to repay its €1.9-trillion of debt. The confidence-building process started with the resignation of Silvio Berlusconi as prime minister late last month. He was replaced by the sober-minded economist and euro-phile Mario Monti, who urged parliament to approve the inclusion of balanced budget principles in the constitution.

On Sunday, Mr. Monti's technocrat cabinet approved a €30-billion program of spending cuts, tax increases and growth measures that gained investor and political approval in the euro zone. Speaking at the Foreign Press Association in Rome on Monday, Mr. Monti said Italy would go "into a situation similar to Greece" without the new measures.