By Ralph Atkins
“Events in Greece have brought the euro area to a crossroads: the future character of European monetary union will be determined by the way in which this situation is handled.” Jens Weidmann, Bundesbank president and European Central Bank governing council member, Hamburg, May 20.
By rights, the ECB could have abandoned Greece long ago. Nothing in the rule book says it must prop up countries at risk of economic collapse. If anything, the architects of the monetary union, launched in 1999, envisaged the opposite. Because members would share a currency but not spending and tax policies, governments were meant to take responsibility for their own finances – the “no bail-out” principle was enshrined in a European Union treaty. Logically, a nation that flouted the rules as recklessly as Greece should be left to its fate.
Faced in recent weeks, however, with the renewed fears of a Greek default, the ECB has balked. With increasing vehemence, the euro’s monetary guardian has warned of catastrophic effects across the 17-country currency union. Jean-Claude Trichet, ECB president – with less than six months before his eight-year term expires – has refused to discuss any debt restructuring for the nation, storming out of a meeting of eurozone finance ministers in Luxembourg this month when it was raised.
His colleagues, including Mr Weidmann of the Bundesbank, have raised the stakes. They warn that if politicians take even a modest step towards a restructuring, the ECB will cut Greek banks off from its lifesaving liquidity supply, triggering a financial collapse that would push the country’s economy into the abyss. It is the central bank equivalent of nuclear deterrence: defy us and we will blow up the world.
How the ECB responds to the conflicting pressures created by the Greek crisis matters enormously. Shunned by financial markets, the country’s banks survive only because the Frankfurt-based central bank meets in full their demands for liquidity against collateral of rapidly declining quality. Early next month, the ECB has to decide whether to continue that eurozone-wide “unlimited liquidity” policy; so far it has said it will last only until early July. The bank also owns about €45bn of Greek government bonds, acquired during the past year as part of efforts to calm financial market tensions.
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Mr Trichet has piled pressure on Athens to reform its uncompetitive and overregulated economy, especially through an accelerated privatisation programme. But if this fails, he or Mario Draghi, the Italian central bank governor expected to succeed him on November 1, will face a dilemma. They will have to decide whether the ECB pulls the plug on Greek banks, leaving governments to decide whether to rescue the country. Otherwise, they will have to jettison the rule book completely and throw money at the problem, perhaps rescuing the euro but at enormous cost to its long-term credibility.
“All of those options are potentially lethal for the eurozone,” says Thomas Mayer, chief economist at Deutsche Bank. Taxpayers elsewhere, particularly in northern Europe, may revolt at demands for fresh help. “But the ECB becoming a backstop for Greece would amount to ‘monetary financing’ [central bank funding of governments], which is forbidden by European Union treaty.”
For the ECB, the turning point was last May. Brutally exposed by the recession that hit Europe after the collapse of Lehman Brothers investment bank in September 2008, Greek fiscal problems exploded into a eurozone-wide crisis. Financial market tensions rose alarmingly as fundamental flaws were exposed in the construction of the monetary union.
The ECB helped persuade eurozone political leaders to assemble a €750bn rescue plan with the International Monetary Fund. It also took action itself. For Greece, it suspended the minimum rating requirement for government-backed collateral used in its liquidity offers, a concession since granted to Ireland. Greek banks could continue to tap the ECB for funds, no matter how far the country was downgraded by rating agencies (it has now reached “junk” status). For the eurozone as a whole, the bank stepped up the provision of unlimited liquidity.
The ECB attracted far more controversy when it decided to start buying eurozone government bonds. The immediate objective of the “securities markets programme” was to try to calm the markets. Officially, it would ensure market interest rates remained in line with the rate deemed necessary to control inflation. But many, especially in Germany, feared it was aiding and abetting fiscally irresponsible governments, violating the spirit of eurozone rules. Axel Weber, then Bundesbank president, publicly opposed the policy. In private, as many as four other ECB governing council members opposed the step.
By declaring it would act as a backstop in bond markets, the ECB bought the eurozone time. A year later, however, the securities markets programme has failed. The debt crisis has spread to Ireland and Portugal, both now subject to ECB-backed international bail-out plans. Greek bond yields have soared this week to record highs as investors shun the country’s debt, with nervousness spreading to countries such as Spain.
Although accounting together for only about 5 per cent of eurozone gross domestic product, Greek, Irish and Portuguese banks today take about €242bn of ECB liquidity – 55 per cent of that provided to the eurozone financial system. The ECB stipulation that it provide liquidity only to solvent banks against adequate collateral has been pushed to the limit.
As such, the risks and conflicts of interest the ECB faces have multiplied. Under the securities markets programme, it acquired €75bn in government bonds, almost two-thirds of which are Greek. It also has on its books perhaps €150bn in other financial assets put up as collateral by Greek banks, much of which is backed by Athens.
Should Greece default, the value of those holdings would decline sharply. The ECB bought the bonds at market prices, which assumed some risk of default, so the immediate losses might be manageable. JPMorganChase calculates that, with €81bn in capital and reserves, eurozone central banks could withstand even a 50 per cent “haircut”, or discount, on Greek bonds. But if writedowns on Portuguese and Irish bonds followed, eurozone governments might be forced to provide billions of euros to rebuild the ECB’s balance sheet.
According to one view, the ECB has been caught by the consequences of actions it took a year ago. “They are basically trapped. They are now like many people in the banking system in calling out for no debt repudiation because they are so exposed,” says Charles Wyplosz of the Graduate Institute in Geneva.
The ECB’s role was deliberately limited, unlike those of “activist” central banks such as those of the US and UK, Prof Wyplosz argues. “We knew there would be a risk of indiscipline by member states such as Greece. In a monetary union without a fiscal union, you have incentives for governments to piggy-back on the prudence of others and a currency regime that protects you from an immediate financial market backlash.”
Another, more charitable, explanation is that the bank finds itself obliged by the mistakes in the eurozone’s construction to act pragmatically. “The ECB sees that over the past half century, the economic systems of advanced countries have become based on bank leverage and inter-linkages that are predicated on the assumption that governments don’t default,” says Julian Callow of Barclays Capital. “If you did have any kind of debt restructuring, even a ‘soft’ one, that assumption would really be shaken.”
What will happen next? Possibly helping the ECB are brighter economic prospects for the rest of the eurozone, which have boosted the chances of countries such as Greece easing their plight through economic growth. But in another sense, robust growth in countries such as Germany and France has compounded the ECB’s difficulties – it is much harder to set interest rates for the zone as a whole when there is a real chance of a big economic shock – a default – from one of its smallest members.
The immediate priority is to put Athens’ reform programme back on track. The ECB, with the European Commission and IMF, is part of the “troika” negotiating measures to restore Greek public finances to a sustainable basis. As part of those efforts, it is working on Greek banks’ funding plans – thrashing out ways to reduce their dependence on its liquidity. Similar plans are being drawn up in Portugal and Ireland. Once they are ready, the ECB could edge towards the pre-crisis system of auctioning liquidity rather than simply providing banks with as much as they need.
But to escape the potential dilemma it faces over Greece – as well as Ireland and Portugal – the ECB requires eurozone governments to take over responsibility for resolving the immediate crisis and the longer-term problems facing the monetary union. So far, their willingness has fallen short of hopes in Frankfurt. This year, Mr Trichet lobbied for EU rescue funds set up following last year’s crisis to be given powers to intervene in government bond markets, allowing them to act as backstop instead of the ECB. He was rebuffed.
The bank is disappointed, too, by steps taken to beef up eurozone fiscal rules to prevent Greek-style crises; it wants financial sanctions imposed automatically on the worst offenders. And it has been alarmed by German attempts to make explicit the circumstances in which private investors would be hit in future bail-outs. In its view, Berlin’s crass understanding of financial markets has scared off potential outside investors in countries such as Greece.
If Greece now requires fresh outside financial help, the ECB will probably lobby for governments to improve the country’s €110bn programme. But with euroscepticism rising in Germany and elsewhere, its appeals may fall on deaf ears and pressure for other ways to relieve Athens’ debt burden would build.
The ECB fears an orderly restructuring would be hard, if not impossible, to pull off – and would risk triggering a bigger, far more damaging Greek default. But, says Mr Mayer of Deutsche Bank, its objections suggest “it has not studied the Latin American experience enough”. During the 1980s and 1990s, Latin America learnt difficult lessons on how restructurings could if necessary be implemented.
Policymakers in Frankfurt have not given up the idea that Greece will spare them such a choice. They take comfort from signs of progress this week in Athens on structural reform plans. If Greece does head towards restructuring, the ECB’s only hope will be that its cataclysmic warnings were wrong. A blow to the bank’s credibility, for sure – but the stakes are so high, even that would be a relatively small price to pay
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