ECB FOCUS-Just baby steps on liquidity withdrawal in Q2

* July expiry of 12-month tender weighs on ECB exit plans

* Southern Europe turmoil also gives pause

* ECB not to follow Fed's discount rate hike

By Paul Day and Sakari Suoninen

FRANKFURT, Feb 25 (Reuters) - With economic recovery in Europe uneven and Greece facing a debt crisis, the European Central Bank is likely to unwind its ultra-loose monetary policy only slightly in the next few months.

The U.S. Federal Reserve's discount rate hike last Thursday will have negligible impact on the ECB's plans, according to a Reuters poll, and analysts expect it to refrain from following suit by raising its overnight lending rate or speeding towards the exit.

The ECB cut interest rates to historic lows to prop up banks and the economy during the financial crisis, and started to lend banks all the funds they requested at its benchmark refinancing rate, as well as lending over longer periods than usual.

In December it unveiled plans to start pulling back those measures by eliminating the 12- and 6-month tenders, but kept its so-called "kindergarten mode" of full allotment at fixed interest rates for other lending operations.

After the ECB's next policy meeting on Mar. 4, its President Jean-Claude Trichet will announce whether it plans to pull back further, or extend the status quo for another quarter.

The monkey on the ECB's back is the July expiration of its first 12-month tender, which drew record demand of 442 billion euros ($596 billion). It has to tread carefully and make sure liquidity is adequate to avoid hurting banks and squeezing financial markets when that sum comes out of circulation.

Given the debt market risks posed by the scale of Greek deficits, the ECB will likely continue its full allotment policy until at least early in the third quarter, analysts said.

"There will be an exit at some point, but uncertainty has increased over the last couple of weeks, so I do not expect them to change anything significantly in the March meeting," said Goldman Sachs economist Dirk Schumacher.

But the ECB is not likely to leave its exit plans completely on hold either. Analysts said it would move a bit in the second quarter to signal progress towards normality as planned, but will avoid anything that might alarm fragile markets.

"Because the market is still very vulnerable and with what's going on in southern Europe, it all has to be little steps, but clear steps," a euro zone money market trader said.

JULY JITTERS

Policymakers have flirted with reintroducing auctions in three-month operations -- the longest remaining tenders -- but keeping the main refi operations at the flat rate and full allotment.

"The most likely next issues in our discussions will be the gradual return to normal tender procedures in the longer-term operations," ECB Governing Council member Axel Weber told Reuters earlier this month.

Some central bank sources told Reuters they would prefer to conduct three-month tenders with auction procedures as early as the second quarter, while others said they would like them to be continued at full allotment for longer.

Banks would still be able to get all the funds they need in shorter tenders, keeping liquidity ample and bank lending going.

"Arguably, the longer the money is, the better, but more important is that there is still full allotment," said Goldman's Schumacher, who expects the ECB to wait until the third quarter until it returns to auctions in all liquidity operations.

And while the market would prefer to have long-term funds to replace the 12-month money, short-term funds would also avoid market malfunction.

"Liquidity is liquidity," the money market trader said.

As money markets have steadied since last year, banks need less reserve liquidity, the trader said. He expected extra liquidity sloshing around the system to be cut to maybe 70 billion euros in July from some 180 billion now.

But the ECB is also likely to reassure investors it keeps the economic recovery as its top priority, which would keep liquidity withdrawal slow and main policy rates on hold.

Even if long-term liquidity operations go back to auctions, this need not mean a wholesale return to pre-crisis liquidity management.

"They could make sure that the allotments that they would announce would be greater than their assessments of the system's needs," said RBS economist Jacques Cailloux.

"If they go straight back to the old model, this would be a bit of a dangerous bet."

SOVEREIGN WORRY

The ECB will also keep a keen eye on the availability of funds for sovereign borrowing when it decides on removing more of its non-traditional measures.

Greece has been pounded by financial markets after revealing its 2009 budget deficit was 12.7 percent of its gross domestic product (GDP), and the premium investors demanded for holding Greek 10-year bonds rather than German Bunds hit a euro lifetime high of around 405 basis points in January.

So far, government debt auctions in Greece and in other high deficit countries in the euro zone have attracted good demand, but if there were less money in the system, this might change.

Greece needs to borrow or refinance about 53 billion euros this year, including 20 billion in April and May.

"The idea is that the ECB removes liquidity, but it's going to have to do so slowly and carefully if it wants to avoid doing an enormous amount of damage to the market," another euro zone money market trader said.

"Treasury debt has seen massive demand recently, but without the ECB liquidity this demand is going to disappear."

Lower demand would probably drive up borrowing costs for troubled southern European countries and further complicate their finances.

Markets have also worried about how the stresses in government finances might affect commercial banks there.

The ECB will gather information from its final 6-month tender demand on Mar. 31 to gauge the health of southern European banks.

"That will be a great test for demand for euro liquidity from peripheral parts of the euro zone," Tullet Prebon economist Lena Komileva said.

But markets are left guessing how much of the demand comes from the southern fringe: the ECB does not make that information available.

(Editing by Ruth Pitchford)