Speaking just hours after Spanish Prime Minister Mariano Rajoy warned his country faces “extreme difficulty,” Draghi said yesterday that talk of the ECB starting to withdraw its support for euro-area banks is “premature.” At the same time, in a nod to growing inflation concerns in Germany, he said the ECB won’t hesitate to counter price risks if needed. Policy makers left their benchmark rate at a record low of 1 percent.

The ECB has expanded its balance sheet by about 30 percent since Draghi took office in November, pumping more than 1 trillion euros ($1.3 trillion) into the banking system in a bid to stem the debt crisis. Pressure to unwind the emergency measures is rising in Germany, where workers are winning some of the biggest pay increases in two decades, threatening to stoke inflation.

“Premature Bundesbank calls for an ECB exit strategy have now triggered a new round of market wobbles, with a focus on Spain,” said Holger Schmieding, chief economist at Berenberg Bank in London. “The risk of a new irrational market panic remains serious.”

Spanish Yields

While the ECB’s three-year loans to banks have helped ease tensions on financial markets, lowering borrowing costs for debt-strapped governments, bond yields are rising again in Spain.

The euro area’s fourth-largest economy sold 2.59 billion euros of bonds yesterday, just covering the minimum amount targeted. After the auction, yields on the country’s ten-year bonds surged to more than 5.6 percent, the highest in three months.

“Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves,” Rajoy told a meeting of his People’s Party as he seeks to push through the deepest budget cuts in three decades.

Declining to comment directly on the Spanish auction, Draghi said governments must make use of the window of opportunity created by the ECB’s emergency measures to deliver on promised structural reforms and fiscal consolidation.

Exit Pressure

Draghi faces pressure from some ECB policy makers to start planning an exit as higher energy costs keep euro-area inflation above the central bank’s 2 percent limit and price pressures brew in Germany.

Two million public service workers in Europe’s largest economy will get a pay increase of 6.3 percent by the end of next year under a deal struck with the government, according to the Ver.di union. IG Metall, Europe’s biggest labor union with about 3.6 million workers, is demanding 6.5 percent more pay.

The ECB hardened its tone on inflation in yesterday’s policy statement, saying “all the necessary tools are available to address upside risks to price stability in a firm and timely manner” and that it will pay “particular attention to any signs of pass-through from energy prices to wages.”

Still, Draghi said the economic outlook is subject to downside risks and inflation will remain contained in the medium term.

‘Stuck’

“The combination of inflation and sovereign debt risks essentially leave the ECB stuck between a rock and a hard place,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “The central bank is likely to keep interest rates and non-standard measures unchanged for the foreseeable future.”

Widening economic divergences in the 17-nation euro area and the threat of the debt crisis intensifying again make it harder for the ECB to set its “one-size-fits-all” policy.

The European Commission forecasts growth of 0.6 percent in Germany this year and contractions in Italy, Spain, Belgium, Greece, Cyprus, the Netherlands, Portugal and Slovenia. The euro-area economy is projected to shrink 0.3 percent.

“Single monetary policy naturally focuses on maintaining medium-term price stability for the euro area as a whole,” Draghi said. “It is up to national policy makers to foster domestic developments which support the competitiveness of their economies.”

Spanish Woes

Spain is struggling with unemployment in excess of 23 percent and a budget deficit that hasn’t been under the European Union’s 3 percent limit since 2007. Investors began to doubt the country’s ability to carry a debt load of nearly 80 percent of gross domestic product last year after the debt crisis spread beyond Greece.

In defending budget reductions worth more than 27 billion euros to cut 3.2 percent from the national deficit, Rajoy raised the specter of an international bailout that would see Spain join Greece, Ireland and Portugal in needing EU and International Monetary Fund aid.

“We remain concerned about the risk of another bout of financial market tensions linked to the debt crisis, and note the troubling rise in bond spreads in both Italy and Spain in recent weeks as a potential early sign of re-emergence of market stress,” said Simon Barry, chief economist at Ulster Bank in Dublin. “On balance, we think that if there is to be a move in ECB interest rates this year, it’s more likely to be a cut rather than a hike.”

To contact the reporter on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

http://www.bloomberg.com/news/2012-04-04/draghi-scotches-ecb-exit-talk-as-spain-keeps-debt-crisis-alive.html

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