A Crisis Averted in Greece, but More Problems Lie Ahead
If all goes according to plan, the Greek parliament’s approval of new austerity measures at the end of June, followed by the euro area’s disbursement of the fifth tranche of the current Greek Loan Facility, will then lead to approval of the latest rescue of Greece by the International Monetary Fund (IMF) Board, just in time to provide a baptism by fire for Christine Lagarde. One of Lagarde’s last major responsibilities as French finance minister will have been to participate in the eurogroup finance ministers’ conference call to seal this deal. (Presumably she was calling from Washington, DC, where she was preparing to take over the IMF the first week of July.) One of her first actions as managing director of the IMF will be to oversee the board’s approval of these same financing commitments. As a lawyer, Lagarde says she can seamlessly review the facts from different institutional perspectives. As a result, disbursement of the fifth aid tranche to Greece now seems virtually certain before July 15th.
The latest crisis has been averted. But multiple obstacles remain in the months and years ahead.
Principally, there is the issue of the "private sector involvement" (PSI) to reduce the Greece’s financing burden in 2012-13. The eurogroup signaled its intention [pdf] in this regard, by promising to "define the modalities for voluntary private sector involvement with a view to achieving a substantial reduction in Greece's year-by-year financing needs, while avoiding selective default."
Their intention to bring about a "substantial reduction" in Greek financing needs, however, conflicts with the goal of avoiding a "selective default." Inevitably, the larger the PSI, the higher the chance for a selective default declaration by the credit rating agencies. It was not unexpected, for example, that Standard &Poor (S&P) would label the "voluntary" rollover of debt [Morningstar subscription required] by the French Banking Federation (FBF) and other creditors as amounting to "a default under our criteria."
It is more certain than ever that some form of PSI will now be part of the financing for Greece. On July 1, for example, the Institute for International Finance (IIF) declared it would work "to deliver substantial cash-flow support to Greece, as well as to lay the basis for a more sustainable debt position." Discussions between the eurogroup and the IIF this week will provide more clarity. But it should be recalled that "PSI now" was a political demand by some AAA-rated euro area countries to provide more funding to Greece and avoid a default in July. In addition, eurogroup acceptance of the final version of PSI will be a political decision, with ultimately limited costs imposed on the euro area banks.
For its part, the European Central Bank (ECB) will not let the credit rating agencies force a cutoff of aid to Greece, pushing it into the economic abyss. Given the likely continued skepticism by credit rating agencies toward any kind of debt restructuring, however, the solution involving PSI is likely to be messy.
But Europe’s institutional ability to muddle through is, as usual, not to be underestimated. Even if the ECB ends "business as usual" with regard to Greek collateral, Greek banks would still have alternative liquidity options.
In Ireland in December 2010, for example, the ECB did not stop accepting all Irish bank collateral but instead limited its acceptance of that collateral to €130 billion (more than 80 percent of Irish GDP). The Irish banks, however, needed more than what they could get from the ECB. Filling the breach, the Central bank of Ireland provided "emergency liquidity assistance" (ELA) worth €50 billion (or 30 percent of Irish GDP) through its "domestic national bank balance sheet." This aid was predicated on collateral that was certainly of worse quality than what was demanded by the ECB.
As described in Buiter et.al (2011a1, 2011b2), the ability of the Irish central bank to do this rested on article 14.4 in the Statute of the ESCB (European System of Central Banks) and the ECB. The statute states [pdf] that "national central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB."
In other words, the ECB by a 2/3rd majority retains the right to block any national bank ELA, and therefore probably the right to attach conditionality to its approval, especially with respect to ELA size, lending costs (certain to be higher than for normal ECB liquidity provisions) and potential loss sharing arrangements.
It could thus be feasible for the Bank of Greece to invoke the understanding that any collateral losses suffered through a Greek ELA would be covered solely by the Greek national bank, rather than distributed across the euro area according to the ECB capital key, and then to establish a national ELA to provide Greek banks with liquidity in the absence of full ECB access for Greek banks.
Substantial losses by the Bank of Greece through such an arrangement would almost certainly wipe out the capital of the Bank of Greece and require the Bank of Greece to be recapitalized by the Greek sovereign. Greek banks currently receive about €100 billion in funding from the ECB, while the capital of the Bank of Greece itself amounts to just over €100 million at €111,243,361.60.
In light of the parlous state of Greek government finances, such a potential recapitalization would obviously only be possible with outside support. In reality that means more financial help from the other euro area countries. Accordingly, an approval by the ECB of a national Greek ELA would amount to a "back over to you" message to the finance ministers, reducing their own ECB balance sheet exposure to Greece implicitly be increasing that of the euro area governments bent on avoiding a Greek default.
In the process, the Bank of Greece would be providing its banks with liquidity implicitly backstopped by a euro area sovereign guarantee. Ironically, the ECB—in trying to reduce its own exposure to Greece—would be setting up the Bank of Greece (rather than the ECB itself) as facilitating another "Greek shadow bailout." (Hans Werner Sinn would surely not be pleased.)
Other differences exist between Ireland in December 2010 and Greece in July 2011. The ECB placed curbs on Ireland’s eligible collateral, limiting its exposure to Ireland to about €130 billion. It can be debated whether Irish banks had more than €130 billion worth of collateral deemed eligible by the ECB, but it is clear that the ECB continued to accept most such Irish bank collateral.
In the case of Greece potentially in July 2011, the restriction on eligible collateral is instead qualitative. Greece would be unable to post collateral with a selective default rating attached to it. This raises the issue of just what a credit rating agency "default declaration" for Greece means in practice.
The most likely rating action following the type of PSI currently being negotiated would be a "selective default" (SD rating). This would mean that Greece had restructured some, but not all, of its government bonds. Such a rating on Greek bonds rolled-over with PSI in 2011 would only be temporary, however. As stated by Standard & Poor’s (S&P) on July 4: "….[w]e would assign a new issuer credit rating to Greece after a short time reflecting our forward-looking view of Greece's sovereign credit risk. At the same time, we would likely rate all debt issues, including debt refinanced between 2011 and 2014 under the FBF options, at the same level as Greece's new issuer credit rating."
In other words, an SD rating for Greece would likely last a "short time" after which Greece could regain its current dubious rating of "only junk." Under the ECB’s normal collateral rules, this step would restore the eligibility of Greek banks’ Greek government collateral to the ECB’s normal repo transactions. To remain faithful (on paper at least) to its claim of not accept defaulted collateral even if all major credit rating agencies declare default3, the ECB governing board would likely only need to approve a sizable Greek national ELA for a relatively short time.
Considering that the actual credit risk exposure of a Greek ELA is implicitly transferred to the other euro area sovereigns, e.g. outside the European System of Central Banks and thereby (in principle) separating monetary and fiscal policy, this might well be acceptable to the ECB Governing Board.
In terms of size, the ECB approved a national Irish Central Bank ELA of about €50 billion in late 2010. It is not clear whether this represented the limit of ECB willingness to accept a national ELA. It could have just marked the extent of total additional liquidity needs of Irish banks at that moment. Considering that Greece is a larger economy than Ireland, and has a 75 percent larger capital subscription to the ECB, a smaller balance sheet than the Irish national central bank in December 2010, ECB acceptance of a temporary Greek ELA larger than €50 billion cannot be ruled out.
Given that currently Greek banks rely on ECB liquidity for about €100 billion, dependent on what other non-Greek government collateral they may possess that would still be ECB eligible even after a Greek government "selective default" rating, a large Bank of Greece ELA might be a sufficient temporary "liquidity bridge" for Greek banks to avoid collapse, even if credit rating agencies declare a default.
What would happen to credit default swaps (CDS’s) linked to Greek government debt in such a scenario is an open question.
Another PSI related issue is the rating and market access of other peripheral euro area countries. Already, the precedent set by PSI for Greece’s second bailout has caused Portugal to get hit by its credit rating reduced to junk status, too. Moody’s expects Portugal (like Greece) to get another bailout from the IMF/euro area, when it is scheduled to return to the financial markets in the 2nd half of 2013 (before the end of Portugal’s three-year program).
In other words, PSI for Greece has clearly already raised the bar for market access for Portugal (and likely soon also Ireland). It has ensured that the new Portuguese government will have to move even more aggressively to implement its IMF program to restore market confidence. PSI for Greece is consequently not costless, and has already triggered some "PSI rating contagion" and "market access contagion" across the euro area periphery.
More worryingly, such "PSI contagion" might also impede the market access of other larger peripheral eurzone countries, such as Spain and Italy, as bond investors begin pricing in even the slightest credit-risk in the euro area sovereign debt markets. This could occur through a "buyers strike," especially if some conservative global bond investors decide to exit the entire peripheral euro area bond market and buy only the euro-safe-haven German bonds.
The multiple challenges facing Spain in the coming years are relatively well-known. The concerns surrounding Italy are mostly focused on the already high general government debt-to-GDP ratio of about 120 percent, a problem compounded by the country’s low potential growth rate.
But while Italy has a very high debt-to-GDP ratio, it is the only G-7 country projected by the IMF to run a general government primary surplus (0.2 percent of GDP). Italy also has the second lowest structural deficit in the G-7 (2.8 percent of GDP). Maintaining solvency in Italy in the face of economic shocks will not require the tremendous additional austerity facing Greece, Ireland, Portugal or Spain. Instead, new policy measures will have to be focused most on increasing Italy’s growth rate. That is an important stabilizing factor.
On the other hand, there is no doubt that Italy—like the rest of the euro area periphery (and indeed the European Union as a whole)—has a very long list of required growth enhancing reforms ahead of it to sustain its government finances. The track record of supposedly pro-growth reforms of Silvio Berlusconi’s government has been dreadful.
If additional financial market pressure could remind Rome that Italy needs to get serious about pro-growth structural reforms, and that tight fiscal policies may no longer do the trick, that would be a good thing.
3. If only one of the credit rating agencies does not declare default, the ECB might simply choose to base its collateral eligibility on that rating, while ignoring the other "default rating."