Greece and the ECB: Negotiations and Brinksmanship

Q: What did the European Central Bank do yesterday that caused a sharp drop today in Greek stocks and bonds?

A:  The European Central Bank said that because it was not confident that a new deal could be struck when the Greek assistance program ends at the end of the month, it would no longer accept Greek government bonds, or bonds it guaranteed, as collateral starting February 11. As long as Greece was getting assistance, the ECB was willing to waive its rule against accepting below investment grade collateral.  It ended that waiver. 

Q: What did the European Central Bank do yesterday that caused a sharp drop today in Greek stocks and bonds?

A:  The European Central Bank said that because it was not confident that a new deal could be struck when the Greek assistance program ends at the end of the month, it would no longer accept Greek government bonds, or bonds it guaranteed, as collateral starting February 11. As long as Greece was getting assistance, the ECB was willing to waive its rule against accepting below investment grade collateral.  It ended that waiver. 

Q:  What will the Greek banks do for funding if they cannot borrow from the ECB? 

A:  Greek banks can borrow from the ECB, but they cannot use the government paper as collateral.  The currently also use other assets.  There is a national recourse.  They can borrow from the national central bank.  

Q:  How does that work?

There is a facility called Emergency Lending Assistance (ELA).  It is through the national central bank, with permission from the ECB.  The risk stays with the national central bank and does not include the Euro system.  It can accept collateral that the ECB will not, but at a price.  Borrowing from ECB can cost five basis points annually.  The cost of ELA funds is 155 bp annually.  The other condition is that the lending must be to solvent banks who are suffering a liquidity issue.  The ECB did raise the amount that Greece’ central bank can lend under ELA to 60 bln euros.  In addition to the normal funding needs, Greek banks have experienced an outflow of deposits over the last two months. 

Q:  Could the ECB prevent Greek banks from borrowing at the ELA? 

A: The ECB has used the ELA authorization to force its will on countries previously.  It did so against Ireland, for example, in 2010.  It actually denied a couple of Cypriot banks access to the ELA, and this forced a restructuring upon them.  Under some scenarios, the failure of the newly elected Greek government to reach a deal with its official creditors by the end of February could spur the ECB into deciding that Greek banks were suffering from a solvency issue and not a liquidity problem.  They could then decide (2/3 vote required) to deny the Greek central bank ELA authority.  This would trigger a deeper crisis and could be the push of Greece out of the Eurozone. 

Q:  Does it really matter? After all, Greece is a very small country.  

A:  There is a debate about this.  Since 2010, when the European phase of the debt crisis erupted, Europe has developed institutional capacity and a backstop, such as EFSF and ESM that make it better prepared to deal with the fallout.  At the same time, the perception is that the banking system is somewhat stronger and there has been a dramatic reduction of foreign exposure to Greek government bonds.  Greece itself is now running a small primary budget surplus.  This means that the deficit that it reports is a function of debt servicing.  Greece’s revenues are a little more than its expenditures outside of its interest payments.  That said, as we painfully experienced with Lehman and reminded recently by the Swiss National Bank’s move, the inter-market relationships are so intricate and complex, market exposures are ultimately opaque, and the law of unintended consequences makes it hard to envision a smooth, non-disruptive exit for Greece.  

Q:  What happens now? 

A:  It is really about negotiations.  The new Greek government won on a platform that was anti-austerity.  At first, it demanded debt forgiveness.  It likely did not really expect it, but it did make its bond swap proposal appear more reasonable.  It wanted to give its official creditors new bonds linked to the country’s growth.  It wanted to give the ECB perpetual bonds in exchange for conventional bonds.  Greece’s official creditors–EU, ECB, IMF, national governments—have resisted any meaningful compromise, so far.  This is about brinksmanship.  The deadline is the end of this month.  The risks that Greece leaves the EMU have increased, but there still seems to be room for a compromise.  Even if one disagrees with the new Greek government, it is more likely than the past governments to improve tax collection, break the rent-seeking behavior of the economic elite and institute pro-growth reforms. 

Q:  Are there strategic interests at stake? 

A:  If Greece were to leave the EMU, it would likely drop into recession and experience high inflation.  There would be a banking crisis and significant social dislocation.  Some of Greece’s official creditors may think such an experience would scare citizens away from their increasing flirtation with other anti-austerity political parties.  We suspect that the opposite is possible; that once it is clear that EMU is reversible; it makes it easier for the next one to leave.  The better Greece does, albeit after the shock, the more attractive its example.  In Spain, for example, Podemos, which shares Syriza’s inclinations, is polling ahead of the traditional parties in an election slated for later this year.  More broadly, if Greece were to leave, it could seek international assistance.  Russia has already offered it.  China may also be interested in Greek ports (potential naval bases) and offshore gas and oil fields.  Greece is a NATO member.

FAQ: ECB and Greece is republished with permission from Marc to Market