The euro zone is discussing the option of financing emergency help for Italy or Spain by using money from national central banks to boost International Monetary Fund resources - but only as a last resort, euro zone officials said.
Italy battled to raise funds by selling 3-year bonds on Tuesday, having to offer a euro life-time high interest rate of nearly 7.89 percent to sell the 7.5 billion euros ($10 billion) on offer.
With euro zone paymaster Germany opposed to the idea of the European Central Bank acting as a lender of last resort, Italy's rapidly growing difficulties in raising affordable finance have fuelled expectations that it may have to turn to the European Union or IMF for aid.
However, it is unclear whether either would have enough resources to bail out the euro zone's third biggest economy unless a special funding mechanism can be worked out.
"If Italy gets into trouble, euro zone countries can decide to increase the resources of the IMF to provide money for the bailout, and they can do that through national central banks, who would simply print the money," one euro zone official said.
"This idea has been discussed, but it is in the background, it is not the main scenario," the official said.
A second euro zone official said the loans could be channeled to the IMF through its new arrangements to borrow mechanism, while Dutch Finance Minister Jan Kees de Jager said it could also involve an increase in IMF special drawing rights (SDRs), which are used in central bank reserves.
"It could be through a general increase in resources -- of the SDRs -- it could be through new arrangements to borrow, so bilateral loans, and it should come from both Europe and non European countries," De Jager told reporters on Tuesday.
A third euro zone official said that while not formally on the agenda of a meeting of euro zone finance ministers on Tuesday, the issue might be discussed informally on the sidelines, after ministers approve guidelines to leverage their bailout fund, the 440 billion euro European Financial Stability Facility (EFSF).
"Despite the attempt to leverage the EFSF, I would agree that the IMF and European Central Bank have to be in the boat," a fourth source said.
The borrowing costs of Italy and of Spain - the bloc's fourth biggest economy - have rocketed as markets worry about their large debts and slow growth and doubt their ability to implement reforms that would fix the problem.
The only institution which could easily supply the cash needed to bail out any euro zone country is the ECB, but European Union law forbids it from directly financing government borrowing.
However, it allows the ECB to lend to the IMF. An opinion, issued by the ECB on Oct 18, 2010, on the request of the Austrian central bank, makes that clear.
"...The financing by national central banks of obligations falling upon the public sector vis-à-vis the IMF is not regarded as a credit facility within the meaning of the Treaty," the official ECB opinion said.
"The ECB came to the same conclusion with regard to laws authorising Banka Slovenije and the OeNB, respectively, to provide payments to the IMF on the basis of bilateral agreements with the IMF," the ECB opinion said.
RESCUE FUND FIRST
The ECB has been buying Italian and Spanish bonds on the market, but not enough to make a big difference. Its policymakers, led by President Mario Draghi and Bundesbank chief Jens Weidmann, are resisting political pressure to ramp up these purchases.
The central bankers want to see those countries receiving aid strictly implementing the economic programmes tied to them, they want governments to kick-start the euro zone EFSF bailout fund and they want them to improve economic governance.
"We should start with the EFSF," added one euro zone central banker.
Only if the EFSF flops and government reforms underwhelm markets do central bankers entertain the possibility of doing more -- and then only if that is consistent with the Treaty and if they have rock solid political cover.
They have highlighted a Dec. 9 summit of European Union leaders as a crunch date for governments to deliver a package to calm markets -- a meeting before which Berlin and Paris aim to outline proposals for a fiscal union.
In the event that these steps fail to resolve the crisis and a euro zone break-up becomes a real risk, some policymakers at euro zone national central banks are privately considering the idea of working with the IMF.
"I could imagine the Eurosystem (of euro zone central banks) playing a role if it works with another institution that brings stronger conditionality," said one euro zone central banker, pointing to the IMF.
But policymakers hope it will not come to that.
They hope that euro zone leaders will send a strong signal to the markets at their summit on Dec. 9 that they are heading towards some form of fiscal union that may end in joint debt issuance in the future.
That would entail intrusive control of national budgets, probably inscribed into a changed EU treaty, or a separate agreement that would be signed by the euro zone countries only.
If the deficit of national budgets is controlled by the EU, this should make it impossible for any country's debt to rise too much, which would also mean that no country will ever default, several euro zone officials said.
If that were the case, the euro zone could even remove any reference to a risk of private bondholder losses in the treaty on the European Stability Mechanism - if there is no possibility of a default, the issue of such losses does not exist.
Policymakers are hoping that since the mention of such losses escalated the debt crisis late last year, the removal of that clause might help to restore some investor confidence.
In the meantime, euro zone leaders could agree on Dec. 9 that they would pass a detailed roadmap towards a disciplined fiscal union, for example, at their next summit in March.
The ECB could therefore substantially step up its Securities Market Programme, buying large amounts of euro zone bonds to give politicians time to implement their plan and Italy and Spain time to reform as promised.
All this could help turn market sentiment back in favour of the euro zone and make it easier for the EFSF to find investors for its Co-Investment Funds, officials argue, allowing the ECB to gradually phase out the unwelcome task of bond buying.