19 August 2012

Piero Ghezzi: ECB limited and conditional lending is not 'what it takes'

Mario Draghi has said he would do "whatever it takes to save the euro". This column asks what 'whatever it takes' means, and whether the ECB is prepared to go that far. It argues that limited and conditional lending improves the odds of success but it is not the game changer needed.

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. The authors 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. 

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. The authors 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...

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.

The authors 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, they think the plan increases the chances of eventual resolution of the crisis. They believe Spain and Italy will eventually make it and would not deny that the ECB plan will help at the margin. But if one defines 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 the authors' 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.

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