In a blog post for the Telegraph, we argue,
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 enough to 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 a full 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.