ECB and Greece

Currency in Crisis

Bundesbank President Weber has been the most candid to date about what the ECB could do in case Greece is downgraded again, especially by Moody's. Recall the problem: Prior to the crisis, the ECB would take as collateral only paper rated A- or better. During the crisis they have extended it to BBB-. It is due to revert back at the end of the year. Fitch and S&P rates Greece below A-, leaving only Moody's above the normal threshold.

The ECB seems to loathe to postpone the return to normalcy again. And yet as Austrian central banker Notwotny pointed out earlier this week, it seems unfair and untenable that a single rating agency determines whether a sovereign has access to the ECB's lending facilities.

A solution, Weber suggests, could be that the ECB accepts the lower quality of collateral in exchange for a larger discount--or what the market calls a haircut. There is precedent. For example, some non-sovereign securities used as collateral are given a 20% haircut.

Weber acknowledges this is not the only solution, suggesting that this is a dynamic situation and the ECB has not made any hard and fast decisions. At the same time, it indicates that although many ECB members, like Weber himself, are insisting on a narrow construction of the Maastricht and Lisbon Treaties, it is not above using monetary operations to assist fiscal objectives.

For example, some of the 12-month money the ECB provided at 1% appears to have been used in part to finance the purchases of European sovereign debt. Indirectly, but no less significantly, the ECB helped support the weaker credits in Europe. On July 1st the ECB's 12-month massive 442 bln euro provision expires. The ECB will seek to smooth this out by offering 6 month funds at the end of March and then a special tender at the end of June.

Meanwhile, reports suggest that Greece has made an early preliminary report to the EU (due March 16th) that claims that it is ahead of schedule in implementing its austerity measures. It is said to acknowledge that, as we pointed out, Greece's 2009 GDP was revised lower and that this lowers the 2010 base. Accounts also suggest that report notes that civil servant wage cuts will will crimp consumption. This is one of the ironies. Efforts to address the structural deficit risks adding to the cyclical deficit.

The markets have responded favorably to these developments and Greek bonds and the other weaker credits in the euro zone have rallied. Ten year yields are off 2-4 bp and credit default swap prices have eased. Note that current market conditions appear favorable for new issuance and there is already talk that Greece could come back to the market as early as next week to raise more funds. Last week's bond sale and the next ones, are part of the official effort to pre-fund a good part of the more than 20 bln euros in maturity and coupon payments due in the April and May period.

The euro has also moved higher on the news. Resistance at yesterday's high near $1.3635 needs to be overcome to spur a retest of the week's high near $1.3705. While many would like to see a near-term euro bounce to sell into, the shallowness of the upticks, given the more positive developments in Greece, over the past week disappoints.