The European Central Bank says the firepower of Europe’s bailout...

The European Central Bank says the firepower of Europe’s bailout fund should be magnified by using government guarantees rather than the central bank’s money market operations.

The ECB says governments should use the 440-billion-euro ($603 billion) European Financial Stability Facility to insure a portion of new bonds issued by debt-strapped nations. That would leverage the amount available to protect member states from the region’s debt crisis.

EFSF resources “should be dedicated to enhance sovereign debt new issuance of securities, thus multiplying their effect,” ECB Vice President Vitor Constancio said in a speech in Milan yesterday.

Policy makers are trying to build a “firewall” around large European countries like Italy and Spain whose size would make them difficult to rescue if their debt became unsustainable. ECB President Jean-Claude Trichet opposes suggestions that the central bank should lend to the EFSF to boost its capacity, saying such a move would not be “appropriate.”

The Frankfurt-based central bank maintains any such arrangement would constitute monetary financing of governments. A guarantee program would allow countries to access more capital without the EFSF exhausting its finite capital reserves.

‘Double or Quits’

“You could basically guarantee a country’s issuance through a so-called zero-coupon bond, assuring investors their capital is not at risk,” said James Nixon, chief European economist at Societe Generale SA in London. “The great advantage is that it is leverage. It is possible it amounts to four or five times the size of the EFSF. The disadvantage is that it is essentially double or quits.”

European leaders may discuss leveraging the EFSF during an Oct. 23 meeting that gropes toward dealing with Greece’s oversized debt, insulating the Spanish and Italian markets, and shielding banks from the fallout.

While European Union Economic and Monetary Affairs Commissioner Olli Rehn said on Oct. 3 that including the ECB in leveraging plans was still on the table, the ECB has underlined its resistance. Economists Daniel Gros and Thomas Mayer have suggested that the EFSF should operate like a bank and borrow from the ECB, using the bonds it purchases as collateral. “There has been a clear understanding that no direct ECB funds will be used,” Governing Council member Ewald Nowotny told reporters in Vienna yesterday.

Copyright Bloomberg