The European Central Bank acted on Thursday to calm euro zone markets and throw a lifeline to Italy and Spain by announcing new steps to keep banks supplied with unlimited, longer-term funds and signaling it was buying government bonds.
ECB President Jean-Claude Trichet said the central bank's program of buying government bonds, inactive since March, was ongoing. Traders said they saw the ECB enter the market as Trichet spoke.
Trichet said the central bank would conduct a special six-month liquidity operation and keep providing unlimited short-term funds to banks at least until next January.
Many banks in Greece, Portugal and Ireland remain totally shut out of market funding and some Spanish and Italian lenders are also dependent on ECB funds.
The European Commission meanwhile urged euro zone leaders to consider increasing the size of their financial rescue fund to prevent the bloc's sovereign debt crisis from continuing to spread like wildfire.
I... urge a rapid re-assessment of all elements related to the EFSF, and concomitantly the ESM, in order to ensure that they are equipped with the means for dealing with contagious risk, Commission President Jose Manuel Barroso said in letter to EU leaders.
EU paymaster Germany rebuffed the call in a swift response. A finance ministry spokesman said it was unclear how re-opening the debate about financial backstops so soon after last month's emergency summit could help calm markets.
The European Financial Stability Facility, which has bailed out Ireland and Portugal and will run a planned second package for Greece, has a maximum capacity of 440 billion euros. It will be replaced in 2013 by a 500 billion euro permanent European Stability Mechanism.
The 17 euro zone leaders left the size unchanged when they agreed on July 21 to widen the funds' role to buying bonds in the secondary market and providing precautionary credit lines to states under pressure on credit markets.
Market analysts and economists say the EFSF would need to be at least doubled and perhaps trebled to pre-empt attacks on larger economies such as Italy and Spain.
Italian and Spanish bond yields fell from 14-year highs as markets anticipated possible ECB action. Spain sold 3.3 billion euros ($3.14 billion) in short-term bonds but had to pay a sharply higher borrowing cost.
Across the globe, Japanese authorities acted to weaken a strong yen, joining Switzerland in efforts to tame currencies buoyed by safe-haven demand from investors fretting about the health of the global economy and the euro zone's debt woes.
Italian Economy Minister Giulio Tremonti voiced apparent frustration at a perceived slow ECB response to the selloff of Italian stocks and bonds in the last 10 days.
I note that the Bank of Japan today launched quantitative easing and the Swiss central bank cut rates to zero. We are waiting for decisions if possible, but desirable (from the ECB), he said.
Tremonti said when he talked to Asian investors, they said: If your central bank doesn't buy your bonds, why should we buy them?
Asked whether Italy was taking adequate steps to strengthen its public finances, Trichet said it was necessary to frontload structural measures. A 48 billion euro austerity program passed by parliament last month delays the brunt of spending cuts until after a 2013 general election.
The chief European economist of credit ratings agency Standard & Poor's said only the ECB could act swiftly to stabilize battered euro zone sovereigns.
Markets are still moving so we need someone to intervene, S&P's Jean-Michel Six said. The only effective fireman capable of rushing out of the fire station at top speed is the European Central Bank, which has played an admirable role since the start of the crisis to calm markets.
He told France-Inter radio that until a contagion-fighting plan adopted by euro zone leaders last month came into effect, which requires parliamentary approval in some countries, the ECB had to play an interim role.
There is strong opposition to reviving the bond-buying policy among guardians of central banking orthodoxy in Germany who argue it compromises the core mission of fighting inflation. German Bundesbank president Jens Weidmann broke off his holiday to attend Thursday's ECB policy-setting meeting.
The ECB bought 76 billion euros of sovereign bonds, believed to be only Greek, Irish and Portuguese, to stabilize markets last year but critics said the Securities Market Program had only limited, short-term impact and did not prevent any of those countries requiring EU/IMF bailouts.
The cost of insuring Spanish and Italian debt against default fell on Thursday and the yield on Spain's 10-year bonds, which had climbed to a 14-year high at 6.50 percent on Wednesday, tumbled as low as 6.12 percent.
Italy's 10-year yield fell back below the psychologically important 6.0 percent threshold.
Analysts say that if yields go much higher and stay there, markets could force Spain, the euro zone's fourth biggest economy, to follow Greece, Ireland and Portugal in seeking an international bailout.
Hearing Zapatero had canceled his holidays showed the situation was desperate. The 7 percent (yield) mark is a psychological barrier and is just not sustainable because it's far too costly to finance at these levels, said Jo Tomkins, analyst at consultancy 4Cast.
Japan sold one trillion yen ($12.6 billion) and its central bank eased monetary policy on Thursday to try to push down the yen against the dollar and euro.
Economy Minister Kaoru Yosano said policymakers of major economies needed to discuss currencies at either Group of Seven or Group of 20 level -- the first official call for multilateral action since twin crises over U.S. and euro zone debt became acute last month.
Official sources in several G7 countries said on Wednesday they were not aware of any move so far to involve the G7 or G20, but that France, which holds the chair of both groups this year, might consult those forums if the turmoil persists.
In addition to Italy and Spain, some investors are becoming jittery about the finances of France, the euro zone's second biggest economy. The spread of 10-year French government bonds above German Bunds hit a euro lifetime high of 0.81 percentage point on Wednesday.
Any major expansion of the euro zone bailout fund would put a greater financial burden on Paris, the second largest contributor to the fund, and could push up its yields further.
(Additional reporting by Sophie Louet in Paris, Marius Zaharia in London, Stanley White and Leika Kihara in Tokyo, Claire Sibonney in Toronto; Writing by Paul Taylor, editing by Mike Peacock/Janet McBride)