BlogSpot - D-Day(s): QE and Grexit

Grexit (redux)

The debate about a possible exit of Greece from the Eurozone is back, with the prospects of the radical left party, Syriza, winning the country’s general elections on January 25th. This early parliamentary election was decided last month, after parliament rejected Prime Minister Antonis Samaras's nominee for president (for the latest election update, see Nomura). Despite refuted reports that Germany was preparing for a Grexit (Bloomberg) and although the European Commission said that membership in the Eurozone is “irrevocable” according to the treaties, there is no more taboo on discussions about Greece possibly leaving the Eurozone.

The situation is different from what it was in 2012 with more limited spillover risks but high costs. The Eurozone’s economy is more solid (Les Echos), a financial safety net and the European Stability Mechanism (ESM), is in place. Fragile economies (Ireland, Portugal and Spain) have implemented structural reforms, and succeeded in reducing public deficit and improving their competitiveness. However, Grexit would be very costly for European taxpayers, affecting investors and citizens’ confidence in the capability of governments to handle the crisis. Joachim Fritz-Vannahme (Bertelsmann Foundation, hat-tip Deutsche Welle) underlines that it’s very difficult to predict the market’s reaction to a Greek default. But this contagion risk seems to be ignored by markets, according to J.P. Morgan (quoted by Reuters), as the yields on Italian, Spanish and Portuguese debt are still at record low levels. Moody’s adds that the likelihood of Greece leaving the Eurozone remains lower than during the peak of the debt crisis, and the risk of contagion also lower.

A new haircut? An alternative solution seems to emerge, with Brussels apparently discussing a haircut for Greece (Spiegel). The conviction seems to be growing that there is no other option to help the country, especially if Greece is not able to return soon to capital markets. This analysis is shared by Marcel Fratzscher, who thinks that about 50% of the Greek debt should be written down (Handelsblatt and Die Presse), leaving Germany with an “acceptable loss” of 40 to 50 billion euros. Though Benoît Coeuré (France 24) reminds us that Greek bonds bought by the ECB since 2010 could not be restructured, because “it is illegal and contrary to the treaty to reschedule a debt of a state held by a central bank.”

A Lehman Brothers scenario? The Guardian presents a more pessimistic scenario where Grexit renews fears of a euro breakup, affects peripheral spreads and reduces the efficiency of the ECB’s expected QE. A small country’s exit from the Eurozone is riskier than doing a new haircut on the debt, because “currency is probably the only issue which touches the economy in more places than banks do”, JP Morgan analysts warn, adding that “some investors might not see Greek politics as a special case”, and other countries could take example on Greece. Barry Eichengreen cited by Bloomberg, adds that the consequences of Greece leaving the Euro might be “Lehman Brothers squared.” Jozef Makush disagrees and writes that the Eurozone can now deal with a country’s exit if it did not want to stick to common rules.

Would Grexit benefit Greece’s economy? Hans-Werner Sinn (Spiegel) considers that the Greek government can avert a state bankruptcy, new loans and haircuts, only if it withdraws from the Eurozone, and restores competitiveness through devaluation. Action is urgently needed as the situation in Greece has been deteriorating for years. Guntram Wolff (Bruegel) does not believe rapid depreciation would help Greek exports as weak performance comes from rigid product markets, a political system preventing real change, the lack of meritocracy. Grexit would be counterproductive, by removing the Troika’s help to reform.

A political debate? For the Financial Times, the Grexit issue is a political issue rather than an economic one—as Greece has almost become self-sufficient, with a primary budget surplus and better growth prospects. Alexis Tsipras might prove to be a moderate once in power, as underlined by Klaus Regling. But his election may buoy other left-wing parties (e.g., Podemos in Spain) against austerity. In Germany too, the Grexit issue is first a political one. A poll, quoted by Handelsbatt, finds that 61% of the Germans want Greece to exit the Eurozone if the country does not comply with the measures decided by international creditors.

Will the ECB cross the Rubicon?

For the first time in five years, Eurozone inflation turned negative (-0.2%) in December, reinforcing fears of deflation. But Bruegel points out that there seems to be no consensus in Europe on the dangers of deflation, especially in Germany. Analysts from big investment banks (e.g., RBS, Goldman Sachs) expect the European Central Bank to announce a large program of sovereign debt purchases during its January 22nd meeting. In a Project Syndicate opinion piece, Jean Pisani-Ferry points out that QE has already been priced in, and ECB inaction would be costly as a result.

Calls for rapid action. ECB shouldn’t wait too much before adopting measures to support the economy and make inflation figures go up, Ewald Nowotny explains that monetary policy has an impact only after a long delay. Joseph Makuch supports early action if previous measures (credit easing, measures to support lending, etc.) prove to be unsuccessful, despite being too early to say what exactly this policy would consist of. Peter Bofinger, quoted by Welt, thinks that the purchase of government bonds by the ECB is the right move, despite German accusation of the ECB of expropriating savers. The European Court of Justice added an element to the debate, by saying that the 2012 ECB bond-buying plan did not break EU law—paving the way for QE.

The debate has moved from whether the ECB will move to QE, to how—i.e., to design issues. The ECB has to compromise between investors (who expect a large “surprise”) and core European members who want to minimize risk-taking. A compromise revolves around a few key issues:

Size—While many see a total volume of purchases of up to 500 billion euros, analysts (e.g., RBS) call for an open-ended program until goals are reached. Francesco Giavazzi, Guido Tabellini (VoxEU) argue that size matters!—more than other design issues, and call more a minimum of 60 billion euro a month. Christian Noyer calls for a cap on possible large-scale purchases of government bonds by the ECB to avoid the crowding out of private investors.
Purchasable assets—The menu of options include sovereign bonds, (financial or non-financial) corporates, and development banks (EIB, ESM, EFSF), with an additional question of which maturity to purchase (including ST sovereigns trading at negative yields). Natacha Valla and Urszula Szczerbowicz, from the CEPII, suggest that, instead of buying sovereign debt, the ECB could broaden its purchases to include equity of all sorts, with the benefit that unlike debt instruments, equity cannot default.
Allocation—to adhere to monetary objectives and dispel criticism of monetary financing of deficits, the ECB is seen as likely to stick to its capital, with a potential cap at 20-20% (below Germany’s capital key).
Risk sharing—Several QE plans are under discussion, Reuters underlines, including a hybrid approach to government bond purchases, which would combine the ECB buying debt, with risk sharing across the euro zone and separate purchases by national central banks. This would take into consideration German concerns about how much risk it would take on, without disappointing investors who expect an unlimited intervention. Paul de Grauwe (Reuters) warns that leaving the responsibility and risk of bond buying with national central banks poses a threat to the Eurozone, because investors will have the perception that the Eurozone is not fully unified. Jeremie Cohen-Setton (Bruegel) reviews concerns about what would happen to the EuroSystem’s financial resources if a country defaults and whether this would generate fiscal transfers between member countries.
Seniority—if central bank purchases are senior to private bondholders, this could create some crowding out, though RBS sees this as unlikely given the ECB will buy in the open market. Effectiveness requires central banks to be pari-passu with other creditors.

But will it be effective? Jeremie Cohen-Setton, in a Bruegel BlogSpot, provided a review of arguments for and against an expansion of base money. For Stanley Fischer, the same arguments in favor of quantitative easing that demonstrated their effectiveness for the US economy are valid for Europe too (La Repubblica). Jean Pisani-Ferry adds that, by lowering long-term interest rates, central-bank purchases of government debt can help contain government debt service. QE can also lower the Euro and spur exports, RBS analysts explain, but the confidence/wealth effect on spending and investment is not guaranteed, nor is the credit transmission channel. Lower bond yields will probably not benefit small companies in Europe, because they rely mostly on banks to finance themselves and have a very limited access to the market, unlike in the US and UK, as underlined by Alberto Gallo. Developing and fixing other measures, such as ABS purchases, will be a necessary complement, according to the Action Institute. He writes that government support and structural reforms are equally needed. Tim Worstall is more pessimistic and adds that QE will be too late, and probably too little. RBS analysts consider also that QE by itself would continue making European bonds with investment grades a good trade, but it will hardly push inflation expectations higher – as many of its transmission channels remain impaired.