By Marc Jones and Boris Groendahl
VIENNA, Dec 10 (Reuters) - The European Central Bank will know by January whether it needs to cut its overnight deposit rate and widen the gap with its benchmark rate to help restore normality to the interbank market, ECB Governing Council member Ewald Nowotny told Reuters.
In an interview, Nowotny also played down recent speculation that the ECB may start buying up debt, saying this was not a realistic option for the time being.
Nowotny said it was becoming increasingly apparent that borrowing was getting tougher in the real economy, and it may be wise for government rescue deals to include terms forcing banks to lend to companies. However, he was hopeful that money markets would begin to get back to normal in the new year once banks had balanced their 2008 accounts.
"I'm pretty optimistic ... Starting with the first quarter of 2009 I would expect maybe not a full normalisation (of money markets) but a start of a development with regards to normalisation," he said in the interview conducted on Tuesday.
"If this doesn't function as such we will have to discuss whether this (deposit facility) interest rate should be upheld or whether we lower the interest."
Commercial banks have been depositing vast sums of money overnight with the ECB rather than risking lending it to each other, as is the case when money markets are operating properly.
Overnight deposits at the ECB have regularly topped 200 billion euros in the past few two months amd hit a record high of 297.424 billion last month.
The ECB hopes last week's announcement of a record 75 basis point cut in its key interest rates might start bringing overnight deposits down.
"There are unfortunately still huge amounts (placed in the deposit facility). One hope was that with last week's interest rate cut this would become less attractive to use the deposit facility. So we'll have to wait whether this really will be the effect," Nowotny said.
"At least at the first meeting in January (we will see whether this has worked). All this needs some time but then we would have to have a look."
In early October the ECB changed its rates, narrowing the gap between the main refi rate and the deposit rate to 50 basis points from 100 bps previously.
As a way of restoring confidence in the banking system, the ECB now lends banks as much money as banks want at a flat rate as long as they can offer up collateral in return. The ECB charges 2.5 percent interest on loans and pays 2.0 percent on overnight deposits.
For bankers the half percentage point they lose between the two is a small price to pay for the safety, but for central banks it is a major headache.
Nowotny said the ECB also wanted to rein in the massive liquidity injections into the banking system which it has made during the financial crisis, but it would not do so just yet.
"My personal view is that in the field of financial institutions the worst is over," he said. "In the medium term the expectation is, of course, that money markets will start working again in a normal way, and this is the time for central banks to exit."
FORCING BANKS TO LEND?
However, borrowing was still getting more difficult in the real economy, said Nowotny, who heads the Austrian central bank.
"We have seen a lot of anecdotal evidence (of a credit crunch), but the statistical evidence is shaky. From my point of view there is a clear indication that it is getting tougher," he said. "If we talk to representatives of the real economy it is quite obvious that there are problems (with credit)."
Commercial banks may have to be forced to lend. "Central banks have created a lot of liquidity and the trickling down has been too slow," he said. "My advice has been in Austria that in packages for banks there should be conditions for banks to extend loans to secure at least a minimum level."
Nowotny said there was also a hope that things could improve if the euro yield curve, which inverted as the crisis erupted again in September, begins to return to a more normal shape.
"To a certain extent things will get better as soon as we have a normalised yield curve. We have had an inverted yield curve and therefore the incentive for banks to lend on a longer term basis is not existent."
"We are tending to get a normally-shaped interest rate curve again, with the short end going down and the long end a bit up, and that should be a big incentive for getting back into normal lending conditions."
ECB President Jean-Claude Trichet last week said outright debt purchases were possible. But Nowotny played down the likelihood that the ECB may do this, following the U.S. Federal Reserve and past actions of the Bank of Japan.
With benchmark rates at 2.5 percent, the ECB still has a way to go before reaching zero rates, as Japan did, when it would have to seek unconventional policy tools. But analysts say buying corporate or government debt could provide an alternative way to boost financial markets.
"This is what the Fed is doing but at least for the time being it is not a realistic option for the ECB," said Nowotny.
Offering loans to more non-euro zone countries was an option however, although none was being readied to his knowledge.
In October Hungary's central bank signed a 5 billion euro deal with the ECB allowing it to borrow if necessary.
"The ECB is restrictive as regards to swap lines but lending with first class collateral would be a possibility," he said.
Nowotny, a former vice president of the European Investment Bank, also said euro zone countries could join together to issue bonds, despite some political hurdles.
Such moves could be a more politically palatable way for hard-up countries to receive funds from neighbours, analysts say.
"To a certain extent we do have this already in the form of the European Investment Bank which is one of the biggest issuers of bonds worldwide," Nowotny said. "In addition there could also be some specific programmes that are outside the competence of the EIB. This has to be seen." (Reporting by Marc Jones and Boris Groendahl; editing by David Stamp)