On the eve of the Olympics, European Central Bank president Mario Draghi went to London to assure the markets that the ECB would do "whatever it takes to preserve the euro."
On Thursday, the markets will learn just how much firepower Mr. Draghi is willing to devote to keeping the 17-country euro zone intact as the recession deepens, Spain seeks a bank bailout and Greece teeters on the edge formal insolvency.
What is virtually certain is that he will unveil a sovereign bond-buying program in an effort to bring down the yields of the most distressed countries, notably Spain. But the program is bound to come with strict conditions, to the point that Spain's, and Italy's, dreams of "unlimited" bond purchases is already dying.
The ECB's fear is that endless, no-strings-attached bond purchases would remove a government's incentive to embark on fiscal restraint and structural reform.
Deutsche Bank AG said that "the ECB will avoid the mistake made in Italy in 2011, when the ECB started intervening in the Italian bond market with the SMP [securities market program] but the Berlusconi government failed to deliver on promised reforms."
The expected tough bond-buying conditions will make it less likely, though not impossible, for Spain to ask the ECB to come to the rescue. Mr. Draghi's message is that government leaders, not the ECB, will have to do the heavy lifting to fix their countries finances; the bank will only act in emergency situations, when the viability of the euro itself comes under grave threat.
On Monday, German Finance Minister Wolfgang Schaeuble warned investors and governments not to expect the ECB unveil miracle cures for the debt crisis on Thursday. "We have to be very careful that we don't raise false expectations," he said in interview with Deutschlandfunk radio.
In Europe, markets and the euro rose Monday on the expectation the ECB will put some flesh on its bond-buying program and might drop interest rates as more evidence emerges of a deepening recession.
Analysts are divided on the likelihood of another rate cut. Slowing economic activity – euro zone manufacturing contracted for a 13th straight month, according to purchasing managers' index released Monday – works in favour of a cut. Working against one is rising euro zone inflation. In August, it was at 2.6 per cent, well above the ECB's 2 per cent target.
Details of the bond-buying program, rather than any rate cut, will dominate Thursday's market action in Europe. The broad outline of the program is already known. Mr. Draghi has made it clear that the ECB will not buy bonds on the open market (as opposed to the primary market) unless the government commits to various strict reforms, such as tough austerity measures and programs to make the economy more open and competitive.
But even that would not be enough. Before the ECB wades into the market, the government would have to apply to the European sovereign rescue funds for help. The funds would buy only long-dated bonds and insist on their own conditions. Only then would the ECB buy short-term debt – three years or less – in the secondary market.
What is not known is the conditions under which ECB would swing into action, and how much firepower it is willing to employ. The ECB may reveal that it will only buy bonds if bond yields rise beyond a certain point. Mr. Draghi has not ruled out "unlimited" intervention, though the ECB could reveal that it is opting for volume-based limits.
Whatever Mr. Draghi announces on Thursday is almost certain to meet with disapproval from the Bundesbank, Germany's central bank. the bank's president, Jens Weidmann, has warned that the ECB's bond interventions are tantamount to violating the ECB's ban on financing governments.
Last week, Germany's Bild newspaper reported that Mr. Weidmann has considered quitting over the ECB's plan to buy sovereign bonds. German Chancellor Angela Merkel, however, seems to be in favour of conditional bond purchases if the alternative is asking German taxpayers for more bailout money for countries facing financial ruin.
While the Bundesbank is worried that the ECB will go too far in supporting government finances, the Organization for Economic Co-operation and Development is worried that it will not go far enough as the euro zone approaches a breaking point. "The ECB should act and the sooner it does the better," OECD head Angel Gurria said in Slovenia Sunday. "The ECB needs to tell markets it is ready to act. The whole European system is at stake. The ECB is the big bazooka."