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Friday, January 27, 2012

What keeps central bankers in Frankfurt awake at night – and why should Britain care?

In a blog post for the Telegraph, we argue,

In his speech in Davos yesterday, David Cameron outlined some very sensible proposals for how to deal with Europe's economic crisis. But, almost in passing, he also called for a eurozone “central bank that can comprehensively stand behind the currency and financial system”, implicitly suggesting that the ECB must be ready to provide more cash to struggling banks and governments around Europe. Unfortunately this statement completely misses the intricacies which the ECB and the eurozone face in the coming months.

The ECB’s balance sheet now stands at a pretty scary €2.7 trillion, higher than that of the money-printing Federal Reserve in the US. By buying government bonds and providing cheap cash to banks around the eurozone, the ECB is now leveraged 33 times – up from 24 times only last summer. This means that for every €1 the ECB holds in reserves and cash, it has €33 swirling around somewhere in the eurosystem.

But it isn’t the size of its balance sheet that keeps ECB officials awake at night – all central banks are leveraged – as much as the circa €60bn of (nominal) Greek bonds festering on its books. This (relatively) tiny item has become political dynamite, as Greece is set to default on its debt in March, either through a voluntary agreement with its creditors or by simply running out of money. As creditors and the Greek government are locked in to talks over which one it’ll be, big question is: will the ECB be forced to take a hit?

The question is crucial as the ECB has said in the past that it will not take losses on its eurozone exposure – ever. For the Germans, losses for the ECB would mark a huge betrayal of the Bundesbank-model, in which a central bank is trusted and prudent, and doesn't take on excessive risks – and therefore has the credibility to control inflation. Many German commentators have spent the past year grumbling about the ECB’s back-handed Quantitative Easing and illegal financing of state deficits. The ECB has got around this by purchasing the bonds on the secondary market, but if it took losses on Greek debt, this argument falls.

But at the same time, if “public” bodies, including the ECB, holding Greek debt don’t accept losses in a Greek default, the write-down may not be large enough to give the country even a hypothetical chance of bouncing back, meaning the EU/IMF cannot give it more loans. For the ECB, this amounts to a pretty awful catch-22: accept losses and see your credibility and rationale undermined or reject losses and at worst prompt a disorderly Greek default or possibly just massive distortions in eurozone bond markets.

So what’s the best solution? We’ve long argued for a full restructuring of Greece’s debt (now 60-70%) and reassessment of Greece’s position in the euro. But that looks unlikely right now. Instead, the ECB could be offered an escape route. It purchased its bonds at around a 30% discount. It could accept a 30% write down without taking any losses and would give Greece some additional debt relief. Another option would be for ECB-held bonds to be bought by the euro bailout fund, the EFSF (at cost price), and then submitted by the EFSF to the voluntary restructuring. The EFSF could absorb the losses, though it too may have to deal with some very uncomfortable questions from taxpayers who will have lost money. But arguably it’s better than sacrificing the credibility of the ECB.

Both options would still be a tacit admission of failure by the ECB, since it always claimed it would hold the government bonds it bought to maturity, but it may have little choice.

All of this should concern the British. Not only because the eurozone crisis is linked to the fate of the UK's economy. But also, as Anglo-Saxon commentators are coming out in droves – alongside the UK government itself – in calling for the ECB to load up on yet more eurozone government debt if need be, it should be a reminder: in the eurozone as in the UK there’s still no such thing as a free lunch.

In the end, someone has to pay – and if you want to keep the Germans fully on board, it best not be the ECB.


Idris Francis said...

For several years now we have had The Emporer;s New Clothes pantomime - supposed economists, bankers and politicans keeping the euro afloat by pretending that the national debts will eventually be repaid, and so keeping them on their books at face value - when everyone knows, including them, that the debts are not remotely worth face value

For as long as this farce continues no solution is possible

Blankfiend said...

From my blog, I see the following ECB options:

What are the ECB's options in this regard?

1. Retain the bonds and write down them down from par to the acquisition price. This would be seen, correctly, as debt monetization, and would probably not be enough of a write-down to make a difference.
2. Retain the bonds and write down them down to well below the acquisition price. Again, debt monetization, as well as a hit to the ECB's capital. It could make up the capital hit either through seniorage or a capital call to its shareholders.
3. Sell the bonds to the EFSF at the acquisition price, which will then do the write-down on its books. This would lead to the EFSF's first realized losses, and may serve as a wake-up call to its guarantors that this mess may actually cost their taxpayers some cash.
4. Sell the bonds back to Greece at the acquisition price. This would give Greece about 15 to 20 billion euros of debt forgiveness, assuming 45 to 60 billion par value GGB's acquired at a 30% discount. Of course, Greece does not have the money to buy back the bonds, so that would have to come from its bailout package, lowering the amount available for the future.


Rik said...

Imho the most likely option is:
1.Greek debt sold at costprice to EFSF;
2.EFSF will do the write off to costprice.
3. Which will account to roughly half of 'missing' amount.
4. Most likely rest hidden somewhere else (lower yields/higher PSI etc).

It is in no way clear that Greece will get its money. This is a pretty good time to pull the plug (LTRO has lowered yields considerably). It will not get much calmer at markets.
Plus this involves a huge amount this term, you save that. It is probably better spend for Portugal or saving some Spanish banks.
Anyway if the EZ let Greece get away again with doing nothing structurally (except a lot of talking) nobody will see help as conditional and Italy and Spain will most likely start to act rather Greek.
And nobody will assume that the 'tough' rules in the new compact will have any impact when it is necessary.

The IMF will start to look like an even bigger bunch of idiots in this respect as well. It has to draw a line in the sand and defend it. Put a knife on Greece's throat and use it if they have to. Basically the 'new European approach' doesnot look to be working of the 3 countries now most likely 2 will go belly up. And we see structural reforms of only 1-2% annually, these countries are simply bankrupt.
If democracy makes bigger reforms impossible a reason more just to pull the plug out so they have to. It is probably time to go back to the old harder methods. These had a much higher successrate and involved considerably less funds.
What is good enough for Korea and Thailand is good enough for Portugal and Greece as well.

It doesnot make it really attractive for the ECB to keep buying PIIGS debt this way, when a lot of people try to shuffle some of the losses to them.

lojolondon said...

Please can you highlight the facts of the writedown? The Greek government is NOT offering a 50% discount.
they are offering a 50% discount, with only 15% to be paid on maturity and the other 35% to be paid over 30 years at a nominal interest rate.
Why would any financial institution accept these terms, when they could force a default and claim on their insurance? Even if they settle with the insurance company, they will certainly get better terms!