Who will blink first, Schäuble or Trichet?
June 10, 2011 1 Comment
Germany and the European Central Bank (ECB) are at a stalemate over what to do about Greek government debt. Germany demands significant private sector involvement in returning Greece to debt sustainability, while the ECB has gone nuclear and said that any restructuring or reprofiling of Greek debt will force the central bank to reject Greek government debt as collateral for its lending facilities. Who will blink first?
I think Germany will end up backing down.
Germany’s position was clearly laid out on June 8th in a letter from finance minister Wolfgang Schäuble to his euro zone counterparts and the ECB. In it, Mr Schäuble explains Germany’s demand that private investors be involved in burdensharing through a voluntary bond swap extending Greek debt by seven years.
The credit ratings agencies have all responded by saying that a bond swap, even a purely voluntary one, would be considered a credit event and would result in them downgrading Greek—and due to contagion possibly Irish and Portuguese—sovereign risk.
In response to Mr Schäuble’s letter, chairman of the ECB Jean-Claude Trichet clarified the ECB’s stance in a press conference yesterday. According to the ECB, if Greek debt is downgraded by the credit ratings agencies, it will no longer be eligible as collateral in the central bank’s liquidity operations. However the ECB has not excluded a voluntary debt rollover, which would see maturing bonds replaced with new ones.
Germany’s hardline position on a bond swap seems to have more to do with domestic politics than it does with resolving the Greek debt crisis. Germany’s ruling coalition has been repeatedly hammered in regional elections in the first half of this year as a result of anti-bailout sentiment. The junior coalition partner, the Free Democratic Party (FDP), is hoping to stage its electoral comeback by mobilizing this sentiment. Consequently, by adopting a harder line, Chancellor Angela Merkel’s Christian Democratic Union (CDU) is pandering to the FDP and the electorate in order to curry support.
Even if Germany were to get its way and implement a bond swap without the ECB rejecting Greek government debt as collateral, this still would not return Greece to solvency. It is unlikely there would be significant appetite among banks to volunteer for this programme without incentives attached. Furthermore, a seven year delay is not significant enough to ultimately reduce the mountain of Greek debt to sustainable levels given my growth expectations for Greece over the medium-term.
There is, of course, a chance that the ECB may blink first. While the ECB claims it cannot accept Greek government debt as collateral if the Greek sovereign is downgraded, this is a legal matter and can always be sidestepped. The ECB did this previously with Greek government debt when Greece was first downgraded to junk status. That being said, the ECB seems primarily motivated by concern over its own balance sheet, which is heavily exposed to Greek sovereign debt. The ECB is also rightfully worried about contagion from a Greek debt restructuring or reprofiling.
Furthermore, the potential implications of the ECB’s threat to reject Greek government debt as collateral in the event of a restructuring or reprofiling are so severe, I do not think the central bank’s stance will be tested. If the ECB stopped accepting Greek sovereign bonds as collateral, it would result in a complete meltdown of the Greek banking sector, which is highly exposed to Greek government debt and completely reliant on ECB liquidity to stay afloat.
The ECB’s proposal of private sector involvement through a debt rollover, like the German bond swap proposal, would not return Greece to solvency. It would simply serve to buy more time and kick the can further down the road. This does not change my forecast that Greece will undergo a hard debt restructuring when the European Stability Mechanism (ESM) is implemented in 2013.