The European Central Bank Calms the Storm—for Now
Greek bond yields, perhaps predictably, came down this week after the final announcement of the International Monetary Fund/eurozone bailout plan on Sunday. However, this was less due to the expected announcement of the details of the Greek bailout plan than to the fact that the European Central Bank (ECB) unexpectedly once again decided to throw out its collateral rulebook. It declared that it would accept as collateral "marketable debt instruments issued or guaranteed by the Greek government…until further notice."
This stunning reversal for the ECB in effect permits the bank to accept as collateral Greek debt that the rating agencies have deemed junk. It comes just a few weeks after President Trichet of the ECB insisted that the bank would not change its "collateral policy for the sake of any particular country." Moreover, the timing of this move—just AFTER the announcement of the government-led bailout of Greece—has been intended to allay concerns over the independence of the ECB, so that the bank could be seen as moving "only after the politicians."
This long-delayed and highly politicized sequencing of events seems likely to damage the overall credibility of the ECB. The question for future economic historians will be whether or not the ECB independently could or should have taken this action sooner. Had it clarified its collateral stance well in advance and made it clear that it would always take the sovereign debt of eurozone members as collateral, contagion risks could likely have been contained much earlier (and cheaper for eurozone taxpayers!).
Yet, despite the messy process, the latest ECB announcement is important for several reasons. First, it clears up the issue of whether or not the ECB would accept the debt of any of its own sovereign owners—the 16 individual member states of the eurozone. The ECB will continue to take Greek (or by inference any other eurozone) sovereign bonds as collateral irrespective of rating.1 This at least raises the age-old central bank question regarding whether the eurozone central bank will be willing to assist its government owners through the collateral system in monetizing their debts. Bond vigilantes will not be pleased!2
Second, and more important, the authorities in Europe have taken a decisive step to limit any contagion to the banking system from downgrades of Greek debt by more credit rating agencies than Standard and Poor's. The key phrase here is "marketable debt instruments guaranteed by the Greek government," which is meant to include debt issued by Greek banks, but ultimately guaranteed by the Greek government. Had the ECB not relented on its collateral rules, further downgrades would have shut down the Greek banks' liquidity access to the ECB, which would have produced devastating bank runs and a disorganized Greek default.
In the longer run, the ECB's actions are also good news for Greece. They represent some of the auxiliary "insurance policies" required to avoid contagion to the rest of the eurozone from an inevitable future Greek debt restructuring.
No one at the European Commission, the ECB, or the IMF can give a satisfactory answer to the question about what happens in 2012 in the highly unlikely event that everything goes according to their three-year economic plans. (New data showing the all-important Greek tourism sector is already suffering from lower bookings suggests that the threat of strikes and civil unrest over the summer is already taking its toll on the Greek economy and that much can go wrong in the projections.3)
Does anyone believe that Greece will be able to refinance its debts at 4 to 5 percent yields in 2012—by which time they will be at around 150 percent of GDP—without further financial support? Certainly, the financial markets, where short-term paper has rallied far more than longer-term Greek debt due after 2012, do not believe it. And if they do not, the IMF-eurozone plan is doomed.
Indeed, one can question whether this official sector plan for Greece, which in essence lets the country run up even higher debts than private investors had been willing to allow, should be termed as "aid to Greece" at all. So far it benefits existing creditors (i.e., largely eurozone banks) that get a chance over the next three years to transfer their exposure to the public sector by simply not participating in new Greek debt offerings. They can then have their existing bonds redeemed in IMF/eurozone cash,4 while the Greek population undergoes even more excruciating rounds of sacrifice to atone for their earlier unsustainable practices.
The only way the IMF-eurozone plan continues to make sense is if there is a restructuring of debt that reduces the cost of debt burden for Greece by at least 50 percent. But now at least the ECB has done its homework to make this become reality.
1. In an economic sense, this is comparable to the Federal Reserve refusing to accept Californian IOUs, although as a sovereign country issuing debt, Greece's legal position is different. I am greatly indebted to the insights from continuing discussions with my colleagues Angel Ubide, Adam Posen, Joe Gagnon, and Carlo Bastasin on these issues.
2. This makes it likely that the Bundesbank, with its history of monetary stability, will fight even harder to put one of its own (likely Axel Weber) in place as the new ECB president after Jean-Claude Trichet.
3. I am indebted to Carlo Bastasin for this important point.
4. Note that this transfer of risk from the private to the public sector occurs when eurozone banks will have their outstanding bonds paid back in full from IMF/eurozone cash from now until 2012. This is a different transfer than through the ECB balance sheet mechanism, discussed earlier.