Euro zone rescuer Draghi faces daunting 2013

With two short sentences, the head of the European Central Bank took the heat out of the euro zone crisis this year. In 2013 Mario Draghi has to live up to even bigger expectations.

The ECB's own forecasts suggest the euro zone economy will shrink 0.3 percent next year and markets remain skeptical that the bloc's weaker members, such as Spain and Italy, can fund ballooning government deficits without formal aid programs.

Progress towards closer economic and fiscal union -- deemed essential by policymakers to solve the euro zone crisis -- is likely to be painfully slow in 2013 because two of the bloc's top three economies, Germany and Italy, hold elections.

Draghi's inbox will fill up quickly.

"There will be a lot of focus on preparation for the ECB as the new single supervisor," said Nick Matthews, economist at Nomura, referring to new plans for the ECB to take over supervision of the bloc's biggest banks.

"The other big challenge is the performance of the real economy - does confidence return as the ECB is expecting?"

Draghi had only been in office eight months when he pulled the euro zone back from the brink of break-up by saying in July: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

Although he began 2012 relatively untried at the European level, with Berlin suspicious, the new ECB president won support from German Chancellor Angela Merkel and her nominee on the ECB board, Joerg Asmussen, for his bold plan to save the euro.

That involved the ECB standing ready to buy government bonds in secondary markets to bring down borrowing costs for stricken countries, provided they signed up to a tough program of economic targets.

Draghi's stroke of genius - or luck - was that during 2012 the mere threat of ECB action sufficed to push borrowing costs down by a critical two percentage points for Spain and Italy, without the need to actually intervene.

This was just as well, since the most influential single ECB council member - Germany's Jens Weidmann - opposed the plan.

Clemens Fuest, research director at Oxford University's Said Business School and an adviser to the German Finance Ministry, explained that Draghi's vow to "do whatever it takes" to save the euro and the development of his plan came at a time when Berlin was under intense pressure to hold the bloc together.

"They didn't like (being pushed to do more) and they knew this would take the pressures away from that area," he added.

For a man who likes to say "the proof is in the eyes of the beholder", Draghi will need to deliver on his pledge next year but without triggering another ECB internal schism that would blow the market confidence he has restored.

The first test is already looming. In Draghi's native Italy, the reforming government of technocrat Mario Monti has collapsed and there is no guarantee that elections early next year will deliver a strong government committed to economic reform.

This threatens to take the three-year-old crisis to a new level and further test Draghi's ability to get a convincing policy response from a fractured ECB Governing Council.

The ECB will likely need to activate its new bond-purchase program - dubbed Outright Monetary Transactions (OMT) - in 2013 to ease Spain's borrowing costs. Any intervention will have to be strong enough to show Draghi's pledge is credible.

Bundesbank chief Weidmann would rather not use the OMT at all. Others at the ECB would, and sooner rather than later.

"We would prefer them to apply," one member of the policymaking Governing Council, speaking on condition of anonymity, said with reference to the request for aid from Europe's bailout fund Madrid must make before the ECB can act.

If juggling these pressures is not enough, Draghi also faces the managerial challenge of building up a banking supervisory body at the ECB next year that is both credible but separate from the bank's main business of setting interest rates.

BANKING BEHEMOTH

The ECB's new supervisory role is part of a vision for a more integrated euro zone that Draghi has pushed for since he succeeded Frenchman Jean-Claude Trichet as ECB president in November, 2011.

Under a landmark deal last week, the ECB will have new powers from 2014 that will give it automatic oversight of around 150 of the euro zone's 6,000-odd banks, and the authority to intervene in smaller banks if there are signs of trouble.

The establishment of this single supervisory mechanism is a first step towards a banking union that will lay a cornerstone for closer economic integration.

The Governing Council member, speaking on condition of anonymity, described the banking union as being of "existential importance for the euro zone". It will later include a fund to wind down problem banks and a deposit guarantee scheme,

But he and others at the ECB still worry about how the central bank will handle its new supervisory role without compromising its independence on setting interest rates - for instance by keeping rates low to keep banks alive.

"This institution is starting to be overburdened," said the Council member, who wanted tight rules to delineate the bank's new supervisory role and to separate it from monetary policy.

Draghi's challenge here is two-fold: he needs to put the right structures and people in place to ensure the supervisor operates effectively. But he must also separate it from ECB monetary policy business or risk losing the bank's independence.

Draghi's solution is to keep himself out of the supervision business - a strategy that poses a risk of its own as the ECB must make the new body credible without the authority he brings.

"It's not going to be me who is going to take care of this," he told European lawmakers on Monday. "We have to make sure that monetary policy and supervision are rigorously separated."

TIGHTROPE WALK

One tightrope walk Draghi cannot opt out of its monetary policy: in the past this was mainly the business of setting interest rates to keep inflation in check. This year, Draghi took ECB's monetary policy to a new level with his OMT plan.

In Germany, however, the OMT plan has led to worries that Draghi is moving the ECB away from the Bundesbank model of fierce independence. Before the ECB can intervene under the program, a country must seek help from Europe's bailout fund.

"This means the ECB becomes dependent on fiscal policy decisions, and gives up its independence to a degree," said Fuest, who in March takes over as head of German think tank ZEW.

These concerns echo the views of Weidmann. The resignations last year of his predecessor, Axel Weber, and German chief economist Juergen Stark in protest at the ECB's previous bond-buying plan rocked the young central bank.

While Weidmann has indicated he will not resign, 65-year-old Draghi was only able to secure his OMT plan by isolating the Bundesbank chief. Draghi needs to keep him in a minority of one, or else risk his signature policy plan losing value.

This means Draghi may have to forgo the interest rate cut some at the ECB would like in 2013 to help the euro zone's recession-hit southern economies, just to avoid other hardliners - or hawks - joining Weidmann in opposing use of the OMT.

Euro zone rates are currently at 0.75 percent, higher than Britain's 0.5 percent and the Fed's rate of close to zero.

"Draghi's key task for 2013 is keeping the sharpest weapon the ECB has - the OMT - as sharp as possible by keeping as many of the Governing Council hawks on his side as possible," said Christian Schulz at Berenberg Bank, a former ECB economist.

"If there is a gradual recovery, as expected, his chances are good because another rate cut, which the hawks would not like, would not be needed."

(Editing by Michael Stott)