Tough love is better for Athens in the long term

By Jose Maria Brandao de Brito 2010-02-21 (www.ftchinese.com)
Both by chance and design, the emergency policy erected by the European Central Bank to tackle the financial crisis has, so far, played out quite beautifully. By introducing a limited package of measures aimed at flooding the banking system with easily accessible and cheap liquidity, the ECB last year restored some sense of normality to the eurozone's financial markets.

As 2009 wore on, the liquidity crunch faded and risk premiums in the money markets dropped steadily. Banks used the liquidity provided by the ECB to fund profitable carry trades on corporate and government bonds, prompting a massive compression of spreads in credit and sovereign debt markets. As the financial sector healed and recovery gained traction, the need for a timely monetary policy exit became apparent. Aware of the perils of procrastination, last December the ECB announced the withdrawal of some liquidity measures.

Then, along came the Greek fiscal crisis with the potential of unwinding the progress already achieved. Rather than bow to pressure and delay the exit, the ECB rejected the notion that monetary policy should accommodate member states' fiscal troubles. Implicitly, the ECB regarded the Greek affair not as another exogenous shock meriting further policy stimulus, but as a demonstration of the dangers of excessive liquidity. This explains why the ECB's commitment to an exit did not wane as investors' unease spread from Greece to elsewhere in Europe.

Could this posture be construed as stubbornness born out of a rigid fidelity to an inflation-fighting mandate? Not really. A timely exit will prompt a more resolute fiscal consolidation where it is most needed. Here is how.

Exiting would make ECB funding harder to get and dearer. Banks would scale down carry trades on sovereign bonds, thereby removing the subsidy to public debt imparted by abundant liquidity. This would hurt primarily the government paper of the most indebted countries, whose higher yields made them the main beneficiaries of carry trades. The resulting higher funding cost would encourage fiscal rectitude for the long haul.

As recent developments attest, no eurozone member will be allowed to default, given the catastrophic consequences that could ensue. The risks include contagion to other vulnerable countries and a eurozone implosion owing to heavy exposure of European banks to peripheral debt: according to the Bank for International Settlements, about 90 per cent of the foreign debt – corporate and sovereign – of Greece, Portugal and Spain is held by other European countries' banks, mainly German and French. However inevitable, the eurozone's implicit bail-out guarantee generates moral hazard in the fiscal sphere; something the ECB should fight strenuously – if need be – by rushing its exit strategy.

Aside from fostering fiscal soundness, an exit will help money markets normalise. One pernicious side effect of the ECB's policy was to get banks addicted to easy central bank money. Consequently, demand for interbank liquidity was artificially subdued and market interest rates sank to levels that discouraged the supply of funds, especially in longer maturities. But as the exit unfolds, demand for market funds automatically increases, rates rise and the yield curve steepens. That stimulates money markets – indispensable for kick-starting bank lending to businesses and households and for sustaining economic recovery.

The liquidity squeeze has withered, and so should the policy package assembled to address it. Yet an exit might not be achievable in full; due to a devilish detail. Amid the emergency measures, the ECB relaxed the collateral rules for the liquidity-providing operations, but committed to reinstate the original criteria in 2011. By then, as things stand, the eligibility of the Greek bonds will be dependent on Moody's maintaining its appraisal of Greece, since the other credit agencies' ratings are too low to comply with the original collateral rules.

If Moody's downgrades Greece, its bonds cease to be eligible for ECB refinancing. That could spark a sell-off of Greek debt, with systemic implications akin to a default. If push came to shove, the ECB would probably maintain the exceptional collateral regime. The credibility of the ECB's exit strategy is, thus, hostage to Moody's mood. Hopefully, by 2011, acute anxiety about Greek fiscal sustainability will have abated; perhaps, partly due to the ECB's tough love.

The writer is head of financial markets research at Millennium bcp

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