Analysis: Trichet loses face but leaves ECB a winner

By Paul Carrel

FRANKFURT (Reuters) - On the face of it he buckled.

Just two weeks after he insisted publicly "we say no to selective default," European Central Bank President Jean-Claude Trichet agreed to a deal forged by the leaders of Germany and France that will result in exactly that.

Was he bullied into a U-turn? Another about-turn would look terrible for the ECB, which compromised its principles in May last year by agreeing to buy government bonds despite saying four days earlier it was not even discussing the option.

But a closer look at the detail of the deal struck in Brussels last Thursday shows the outcome is far more nuanced than a simple 'loss' for the ECB on the selective default issue.

Trichet conceded on that point but in doing so he won a broader deal that pushed the cost of tackling the crisis onto governments -- along with a private bondholder contribution that was ringfenced in such a way as to limit the contagion threat.

This assuaged Trichet's two biggest concerns: that involving private bondholders could trigger a Lehman-style meltdown in financial markets, and that the ECB could end up financing an insolvent state and its banks.

German Chancellor Angela Merkel on the other hand got the private sector involvement she needed to sell the deal to lawmakers and voters in Germany at a cost of underwriting Greek debt.

"The ECB and the fiscal agents made peace -- both of them got what they wanted -- that should reassure the market," said Andrew Bosomworth, senior portfolio manager at Pimco.

Trichet played tough in the run up to the Brussels summit, insisting the ECB would not accept bonds in default as collateral in its regular funding operations with banks.

In a high-stakes standoff with the euro zone governments, the collateral card was the closest he had to an ace: refusing to accept Greek sovereign bonds as security would deprive Greek banks of the funds on which they rely, crippling Greece's economy and risking contagion to other euro zone economies.

This stance was aimed at making sure euro zone governments -- with or without the private sector -- assumed the cost of dealing with the crisis, rather than pushing it over to the ECB, which feared its independence being compromised.

The gambit worked.

Although Trichet lost face over the selective default tag, euro zone governments will stump up collateral enhancements so that Greek banks remain able to borrow from the ECB, rather than the central bank effectively printing money to finance Greece.

The governments are also giving the euro zone's EFSF bailout fund powers to buy bonds on the secondary market and they stressed that the involvement of the private sector in helping Greece is unique and will not be applied to other countries.

This should allay the ECB's contagion concerns.

"It looks like we are going to have that selective default occur but that Trichet scored a victory in keeping his balance sheet clean and getting the fiscal agents to provide securities that satisfy the ECB collateral requirements," said Bosomworth.


Trichet, whose term as ECB president expires in October, has established himself as a diplomat as much as a central banker.

A product of France's elite ENA public administration school, he only agreed to the ECB's bond buying program as a quid pro quo for euro zone governments setting up the EFSF.

Last week's deal allows the ECB to extricate itself from the fiscal minefield it reluctantly entered with the bond-buy plan, meaning Trichet can leave his successor -- Italy's Mario Draghi -- a central bank focused again on delivering price stability.

The bond program is a monkey the ECB has been desperate to get off its back. Former Bundesbank chief Axel Weber publicly opposed it and, isolated on the ECB's policymaking Governing Council, quit his post a year early in April.

By granting the EFSF the power to buy bonds, euro zone governments have effectively relieved the ECB of this burden and Trichet can rid the ECB of the fiscal responsibilities it has hated shouldering.

"It will soon again be possible for the ECB to concentrate on its real duty -- monetary policy," said Michael Schroeder, economist at Germany's ZEW economic research institute.

Trichet had to hold his nerve to achieve this outcome.

He flew to Berlin at short notice last Wednesday evening to join Merkel and French President Nicolas Sarkozy, who were already five hours into their meeting to prepare the sweeping debt deal for the euro zone.

Despite joining them late and only in an advisory role, he helped secure a deal that satisfied the ECB's core demands and won a vote of confidence from financial markets.

But the compromise came at a price. As well as losing face over the selective default issue, Trichet risks dissent on the ECB Governing Council from Bundesbank chief Jens Weidmann -- the most powerful of the 17 euro zone national central bank chiefs.

Weidmann opposed default, private sector involvement, and empowering the EFSF to buy government bonds -- a scenario he feared would mark the beginning of a 'transfer union' that would remove incentives for fiscal discipline in weaker states.

The fact the deal involves all these elements will not please Weidmann, who was previously Merkel's economics adviser. He is now at odds with both Trichet and her, leaving a nasty split between leading policymakers in Europe's biggest economy.

Weidmann will not do a Weber and quit but winning back the Bundesbank chief will be one challenge Trichet leaves Draghi, who will otherwise inherit a central bank freer to focus purely on its core inflation-fighting mandate.

"As Trichet hands over to Draghi, there is the potential for Draghi to take the ECB presidency on in better shape and not be forced into crisis management," said Pimco's Bosomworth.

(Editing by Mike Peacock, John Stonestreet)