Next steps in the euro-zone saga – will the ECB use the nuclear option?
The euro-zone and IMF have taken massive action to support Greece but unfortunately it does not appear to have been enough to support market confidence. In a downside scenario where contagion increases further we would eventually expect the ECB to use the nuclear option of outright purchases of euro-zone government bonds. The biggest investment implication of such a move would be further weakness in the euro due to loss of credibility and concerns about the monetisation of debt.
The action taken by the euro-zone and IMF to support Greece has been substantial, but was unfortunately late in coming. A €110 bn package to meet Greece’s financing requirements into 2012 has been put on the table, including a fund to support its domestic banking system. In return, Greece has promised drastic austerity measures. But recent market action shows that the contagion risk from Greece’s problems to peripheral euro-zone bond and equity markets and banking systems has not been eliminated. Greek bond yields are once again moving higher, with two year yields up around 200 basis points (bp) in two days to 15.8%, dragging other weaker markets along. Portuguese 2-year yields are up around 100 bp in two days and Irish and Spanish 2-year yields up 90 bp and 70 bp respectively.
This may be because the large bailout of Greece, and in particular the convoluted way in which the agreement was finally reached, suggests that it will not be possible to engineer a similar package to support another euro-zone country if it gets into difficulty. Portugal, followed by Spain or Ireland, is the most likely candidate to ask for help next. Portugal in particular is already being singled out by bond markets.
Unfortunately, bond-market sell-offs can become self-fulfilling prophecies. For example, if investors do not believe that Portugal can be bailed out by the euro-zone and IMF in a similar way to Greece, they will require a much higher risk premium (bond yield) to invest in Portuguese bonds. Eventually, the cost of finance for Portugal will be too high for it to finance itself in bond markets and it will need to find funds from elsewhere or restructure/default.
Portugal’s re-financing needs, in terms of debt maturing this year, are on a similar level to Greece’s.
Portugal’s national debt-to-GDP ratio, at 76.8% in 2009, is better than Greece’s 115.1%. But its budget deficit, at 15.4% of GDP in 2009, is extremely large. Portugal has also suffered from chronically weak growth since entering the single currency, averaging only 0.9% GDP growth a year. Rating agency Moody’s warned yesterday of a possible downgrade to Portugal, placing its Aa2 government bond rating on review. Portugal is planning to bring forward fiscal consolidation measures, but it may be too little too late.
Spain has a much lower ratio of debt to GDP than either Portugal or Greece, at only 53.2%, though it is also running a substantial budget deficit of 11.2% of 2009 GDP. It has a greater amount of debt maturing, reflecting the fact that it is a much larger economy, with some particularly large bonds maturing over the next few weeks. For example, on 21 May Spain has a €9.2 bn bond maturing and on 30 July a €16.2 bn bond maturing. But it also has the advantages of a high domestic savings rate, suggesting domestic purchasers of bonds could be available in case non-domestic investors are reluctant to buy. The linkages from Spain to the rest of the euro-zone banking system are substantial, with French and German banks alone holding around €320 bn of Spanish assets.
How would a downside scenario play itself out?
In the event that Portugal and/or another euro-zone country such as Spain or Ireland are unable to finance themselves in bond markets at reasonable rates, and that euro-zone member countries are unable to quickly coordinate another rescue package similar to the one put in place for Greece, then we think as a last resort the ECB would be forced to use the ‘nuclear option’ of outright purchases of euro-zone government bonds using newly created money (i.e. quantitative easing), justifying the move on the grounds of financial stability.
During the 2008/2009 financial crisis, the ECB did not deploy quantitative easing in the same way the UK and US did, preferring to provide long-term ultra-low-rate loans to financial institutions instead of engaging in outright purchases of government bonds. The ECB did purchase some covered bonds (i.e. backed by assets such as mortgages), but the amount was relatively small at €60 bn.
But, if necessary, the ECB could justify buying the equivalent of up to 5-10% of euro-zone GDP in government bonds, roughly €450-900 bn on the basis that other central banks have engaged in similar or larger asset purchases to support the financial system recently. Government bond purchases by the UK central bank amounted to approximately £200 bn, or 14% of annual GDP. In March 2009, the US Federal Reserve announced plans to purchase up to $300 bn of longer-term Treasury securities in addition to increasing its previously announced total purchases of GSE debt and mortgage-backed securities of up to $200 bn and $1.25 trillion, respectively. In total, the announced asset purchases amounted to around 12% of US GDP.
In terms of process, the ECB would probably start with verbal intervention, stating that it was prepared to make outright purchases of government bonds, before proceeding with actual purchases if verbal intervention was not enough to stem contagion.
Nuclear option
However, the ECB would regard this option (the monetisation of debt) as very much a last resort. This suggests that substantial financial-market volatility, i.e. a much larger correction in risk assets and even more volatility in financial markets than we have seen thus far in April and May, would be required to trigger such a move. Bundesbank President Axel Weber said yesterday that the threat of contagion from Greece’s fiscal crisis doesn’t merit "using every means" - a coded reference to government bond purchases. In his monthly press conference today ECB President Jean-Claude Trichet was non-committal, saying simply that the governing council had not discussed this option.
Investment implications
Quantitative easing in the euro-zone could raise fears that it would lead to inflation. However, with credit growth still subdued this may not necessarily occur. In addition, the ECB action would probably also be predicated on substantial fiscal consolidation by euro-zone governments, which would offset any inflationary impact from a larger monetary base.
Once the ECB acts, we could see a revival in appetite for risk assets, just as the Fed’s announcement of purchases of US Treasuries in March 2009 marked the low point for equities then. However, the relationship may be less straight forward because of the damage done to the whole euro-zone project and its institutions. Furthermore, fiscal policy would be restrictive to growth, whereas it was expansionary in 2008/09.
Perhaps the biggest impact of a quantitative easing program by the ECB would be to further undermine the credibility of the euro and its historical link with the Deutschemark as a ‘hard’ currency, suggesting further weakness for the single currency in the medium-term even if financial stability was restored.
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