There is broad agreement that the ECB is going to be the main actor in the potential resolution of the peripheral debt crisis. In principle, there are two avenues that the ECB could pursue in its efforts to avoid a full-blown crisis. First, it could ease monetary policy sufficiently to weaken the euro and generate inflation to facilitate growth. We think this route would not be sufficient in the near term and the ECB may perceive it as a breach of its mandate. As a result, it is not the focus of the market or the ECB. A second, more immediate task is to break down the vicious dynamics of higher yields and worsening debt dynamics that is affecting the systemically important peripheral European economies. Can the ECB achieve this objective?
As De Grauwe (2011) and Kopf (2011) have indicated, one of the main problems for the Eurozone is that, unlike the US, UK, or Japan, individual Eurozone countries effectively have 'foreign currency' debt in the sense that their own central banks cannot print the currency in which their debt is denominated. In that sense, the sovereigns lack a lender of last resort. The absence of a lender of last resort means that Eurozone governments are exposed to bouts of fear and distrust in the bond markets. These fears can trigger a liquidity crisis, which can easily turn into a solvency crisis, as higher interest rates and worsening debt dynamics can be self-fulfilling and effectively end up in default. Moreover, the Eurozone’s fixed exchange rate implies that the sudden stops (or reversal) of flows that are currently playing a key role in the European periphery will have a much bigger (negative) impact on economic activity.
The ECB’s limited and conditional lending cannot eliminate default risk
Given these institutional constraints, what can the ECB do to force a good equilibrium once, as it seems now, markets have moved beyond the 'point of no return' in some of the peripheral countries?
In principle, the ECB can eliminate this risk by acting as lender of last resort and capping yields at a level that ensures solvency (unless things turn out badly in terms of economics or policy effort). The 'target' yield would need to be sufficiently low to be consistent with debt sustainability but sufficiently high to maintain the incentives to undertake domestic reforms. This would theoretically eliminate (or at least reduce massively) the risk of default and start a virtuous cycle. However, in order to be 'successful', the ECB would need to be credible that it is going to defend its desired target rate.
This is difficult. Clearly, the ECB has the balance sheet to buy as much debt as needed to defend the target yield it pleases. But in practice, the ECB is unlikely to commit to the magnitude of the intervention that may be required to cap yields for two reasons: a) concerns that moral hazard in policymaking could lead the weakest countries in the Eurozone to lessen their efforts to reduce deficits; b) the ECB may not be willing to accept the associated credit risk.
Instead, the strategy that the ECB is undertaking appears to be different. In conjunction with the EFSF, it is going to provide limited and conditional lending. The question is whether this type of intervention will be enough to rule out the bad equilibrium. We are sceptical that it will provide a sustainable solution in the long term for two reasons.
The first issue is subordination. Mr Draghi commented that “private investors’ concerns about seniority will be addressed”. Despite these assurances, however, investors cannot rule out the possibility that in an eventual restructuring, the ECB would claim seniority regardless of what had been committed before. In addition, Mr Draghi has to face his own inability to renounce irrevocably, on behalf of the ECB, the institution’s seniority in a credit event.
We had argued before that IMF lending, even if senior, could be beneficial to bondholders provided it is very long term and at very low concessional rates. Those benefits could more than offset the effects of subordination. Conditional Securities Market Programs (SMP) would fail on both counts. SMPs are a form of indirect lending but would not take yields low enough for the sovereign and the intervention would be limited to the short end of the curve, according to the ECB. For all these reasons, SMPs would most likely reduce investor interest and potentially increase fair yields.
The second problem is that limited and conditional ECB/EFSF intervention may not reduce yields enough to rule out the 'bad' equilibrium. Because the ECB is unwilling to make unlimited purchases unconditional on the underlying fiscal position, default risk is in the Eurozone not transformed into inflation risk, and sovereigns like Spain and Italy do face a credit risk. The credit risk is compounded by the fact that ECB lending is not only limited but also conditional, because investors have to assign some probability to a scenario in which the ECB bond buying is curtailed because of weak policy implementation.
However, as long as even a small risk of default remains, spreads may wind up being outside the range of (ex post) sustainability. This is not our baseline scenario. We think that the ECB can bring yields down to the 5.5%-6.0% range with limited and conditional lending. And we think that the underlying fiscal dynamics are consistent with solvency at those yields.
But we have to attach a probability of more than zero to the risk that either of these statements may not materialise. There could be a prolonged recession that may undercut political support for further spending cuts, while at the same time pulling the economic rug out from under the public finances. Under this alternative scenario, even interest rates below 5% may not be enough to stabilise debt dynamics and the countries would be de facto insolvent. Since we cannot rule out the possibility of default, the logic of the risk premium and debt dynamics reappear, and hence the vicious circle is not broken.
The conditional lending (direct and indirect) that worked with several emerging market countries in the past may not work with the current ECB/EFSF plan. It is illustrative to use Brazil in 2002 as an example. The country had a primary balance of more than 3.5%, a debt-to-GDP ratio of less than 60% and an average real growth rate of 3%. This meant that the country could afford real interest rates of close to 10% and still keep stable debt dynamics. Since markets had been disciplining Brazil for many years, the country could cope with rates that included large enough implied default probabilities. This is not possible in peripheral Europe.
We are not suggesting that the current ECB plan will fail or that Italy and Spain will inevitably default if the ECB refuses to undertake unlimited and unconditional lending. Indeed, we think the plan increases the chances of eventual resolution of the crisis. We believe Spain and Italy will eventually make it and would not deny that the ECB plan will help at the margin. But if we define success in solving Europe’s debt woes as the ability of Italy and Spain to regain market confidence in the immediate future, the current ECB plan is unlikely to be successful. It is not a game changer as it does not eliminate, in our view, the material risk of failure. To that extent, and absent a(n unexpected) strong rebound in European economic activity, the EFSF/ECB is likely to need to own a very large portion of the debt for a very long time. And if accidents happen and the domestic political support for further adjustment evaporates, the end game will be either default or debt mutualisation. The latter could be lite (either directly through the ECB’s unlimited and unconditional lending or indirectly through the ESM) or full-blown through Eurobonds.
De Grauwe Paul (2011), “The governance of a fragile Eurozone”, Economic Policy, CEPS Working Documents, May.
Ghezzi, Piero (2012), “Official lending: Dispelling the lower recovery value myth”, VoxEU.org, 21 June.
Kopf, Christian (2012), “Restoring Financial Stability in the Eurozone”, CEPS Policy Briefs.