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Europe sees further pain for financial sector

Lower interest rates might not help the euro zone economy despite the impact of further pain for the financial sector, European Central Bank governing council member Yves Mersch was quoted on Wednesday as saying.

In an interview with the Wall Street Journal, Mr. Mersch said official rates at 1 per cent were appropriate and indicated any further easing would have to be carefully weighed.

For his part, Belgium's Guy Quaden said the ECB would only unwind its support when there is a "significant" improvement in the economy - taking a different line from fellow policymaker Juergen Stark, who has said the ECB will withdraw when the recovery starts.

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Mr. Mersch and Mr. Quaden's comments are in line with analyst expectations that the ECB will keep rates on hold throughout 2010 as the 16-nation region's economy edges slowly out of recession, and policymakers differ on whether further support is needed.

"We never pre-commit and we are always flexible," Mr. Mersch said when asked about the ECB's refusal to say 1 per cent is the floor for interest rates.

"However, there are a certain amount of negative side effects associated with very low interest rates. There are also questions of diminishing marginal efficiency."

The Luxembourg central bank chief said money market funds did not thrive in a low rate environment, for example.

He said the recession could batter the 16-nation bloc's strained banking system further, adding the central bank had already factored in more strife for the financial sector.

More financial sector weakness, which could result in more European bank failures, was "already pencilled in" to policymakers' calculations, the newspaper reported.

"That is the reason why we are also cautious about the gradual recovery path in our scenario," Mr. Mersch was quoted as saying.

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While he expected the first quarter of 2009 to mark the depth of the recession, he warned against reading too much into recent signs of stabilisation.

"We are reaching the valley, but we have to walk through the valley," he said in the article.

The ECB expects the region will not record positive quarterly growth rates until mid-2010, and Mr. Quaden said the world and Europe had not yet felt the full effects of the deep recession, especially when it came to employment.

"This is a serious recession but it is not a depression," Mr. Quaden told reporters in remarks released on Wednesday.

As well as cutting rates to record lows, the ECB is also supporting growth by lending banks unlimited funds to keep liquidity flowing and buying €60-billion ($84.66-billion) in covered bonds.

Mr. Quaden said a depression could be avoided only by using extremely accommodative monetary and budgetary measures which have been introduced, but cautioned: "These policies cannot be maintained in the long term."

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"When the economic activity will significantly improve, we will need exit strategies from the very accommodative policies of today with very low interest rates and unlimited supply of liquidity ... large public finance deficits and a dramatic increase of public debt ratio to GDP," he said.

Mr. Stark said on Monday the ECB would reverse its record low rates when the recovery started and inflation pressures rose.

Luxembourg's Mr. Mersch said although the ECB did not rule out increasing the covered bond programme if needed, it was focused on implementing the decision and was not yet planning specific exit strategies.

"We must move away from an announcement policy to an implementation policy," he was quoted as saying.

Finland's Erkki Liikanen also stressed the need for government to unwind public sector stimulus to avoid a debt spiral in an interview with Finnish broadcaster MTV3..

"Public sector stimulus (packages) must always be temporary ... when the situation stabilises then you need balance so that you don't end up in a debt spiral, that's the most important thing," he said.

Mr. Quaden said although the health of the financial system was improving, it was not completely healthy yet and policymakers needed to keep a close eye on lower inflation in light of fears of deflation.

"Many economists fear deflation. They fear a generalised and cumulative drop of all prices, where people will see no reason to spend today when goods will be cheaper tomorrow," Mr. Quaden said.

Mr. Mersch said the risk of both deflation and too-high inflation was remote. Euro zone inflation is expected to turn negative in coming months and remain well below the ECB's 2 per cent ceiling both this year and next.

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