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 enoughto 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 afull 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.
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