ECB boosts capital as EU leaders meet on debt crisis

(Reuters) - The European Central Bank moved to increase its financial firepower in the euro zone debt crisis Thursday, and European Union leaders met for their seventh summit of the year to try to halt the contagion.

The ECB, in charge of monetary policy in the 16-nation euro area, said it would almost double its capital to 10.76 billion euros to cope with increased credit risk and market volatility, with euro zone members providing the increase.

IMF Managing Director Dominique Strauss-Kahn said he was worried about slow growth and the threat of contagion in Europe, while EU documents seen by Reuters described the euro zone's sovereign debt problems as being "systemic."

"The bad news as you say is coming from Europe, where the recovery is really sluggish and where growth is the main problem to face," Strauss-Kahn told a Thomson Reuters Newsmaker event.

EU leaders began a two-day summit at which they are expected to agree changes to the EU's governing treaty to allow the creation of a permanent mechanism for handling financial crises from 2013. But they will also discuss current crisis measures.

The EU, together with the IMF, has set up a 750 billion euro (640 billion pounds) emergency loan fund to provide assistance to highly indebted euro zone states that are unable to finance themselves in volatile financial markets.

EU sources say leaders will discuss the possibility of enlarging the fund, but are unlikely to take any decisions.

Draft documents prepared for European Commission President Jose Manuel Barroso ahead of the summit and seen by Reuters described the crisis as posing a "systemic threat," with Greece and Ireland already receiving aid and Portugal and Spain regarded by markets as potential risks.

"The current sovereign crisis has now become systemic in nature, and is driven not only by budgetary fundamentals but also by the mispricing of credit risk by investors and short-term herding behaviour in the markets," the documents said.

The decision by the Frankfurt-based ECB to raise its subscribed capital base was the first such increase in its 12-year lifetime, a mark of the severity of the situation.

"We infer from this that the ECB ... is seeking a greater cushion in order to offset potential losses, given that its portfolio of securities holdings has risen substantially, as well as to protect itself from potential collateral losses," Barclays Capital economists said in a research note.

The central bank has bought some 72 billion euros in euro zone government bonds since May but has resisted political pressure to substantially step up these asset purchases to help indebted governments avoid having to seek a bailout.

SEVENTH CRISIS SUMMIT

The two-day EU summit comes as Portugal and Spain face growing bond market pressure and calls to overhaul their economies to improve competitiveness.

Strauss-Kahn told Reuters he was concerned about the length of the process Europe was going through to resolve its crisis and said the EU needed to find a "comprehensive" solution.

German Chancellor Angela Merkel, the driving force behind the treaty change to create the permanent European Stability Mechanism from 2013, has sought to keep other ideas, such as increasing the size of the current rescue fund or issuing euro zone bonds, off the summit agenda.
Merkel told reporters on arrival for a conservative leaders' pre-summit meeting in Brussels that setting up the stability mechanism was "a giant act of solidarity" and reaffirmed Germany's commitment to a stable, enduring euro.
The chancellor said earlier she had settled a dispute with Jean-Claude Juncker, who chairs the finance ministers of the euro zone, over his call to issue common euro area bonds, but differences still looked likely to arise at the summit.
"Jean-Claude Juncker and I had a long telephone conversation and cleared up the issue a while ago," Merkel said in an interview with Germany's Bild newspaper published Thursday. "With so much at stake, the emotions sometimes get involved."
The head of the European Parliament, Jerzy Buzek, told leaders at the summit that euro bonds should not be dismissed.
Merkel contends so-called E-bonds would remove the incentive for countries to balance their budgets, and would raise Berlin's borrowing costs. Juncker, who last week called Germany's instant rejection "un-European," confirmed he had made peace with Merkel but hinted he might raise the proposal at the summit anyway.
"I know very well that if there is a debate (on euro bonds), there cannot be a decision one way or the other at today's European summit," Juncker told French daily Liberation, vaunting the benefits of common bonds for reinforcing fiscal discipline.
Ratings agency Moody's warned Spain Wednesday that its debt could be downgraded, saying it was worried by big central government funding needs, indebted banks and regional finances.
Spain's Treasury paid a high premium to sell long-term bonds Thursday but found strong demand, in a test of investors' appetite for euro zone peripheral debt.
Portugal announced extra measures Wednesday to cut red tape and bolster structurally slow growth, in a move to convince EU officials and financial markets it is doing enough to stave off the pressure to seek EU financial aid.
Throughout 2010, EU leaders have struggled to show unity and clear communication in handling the crisis, alternating between rushing out half-formed or contradictory proposals and dithering on the right course of action while markets burnt.
There has been a relative lull in financial market pressure in the past two weeks, ahead of the end of the year when investors and traders traditionally close their books, but analysts expect pressure to resume in 2011 without action.
Belgian Finance Minister Didier Reynders said the EU's portion of the existing crisis fund, totalling 440 billion euros, could potentially be doubled to fend off the threat of renewed market pressure on Portugal and Spain.
"Of course we need to show we have deep pockets," Reynders told reporters.