Greece and the ECB

Quite naturally, financial markets are focussed on events in Greece and for us the key question remains whether Greece will or will not default in the coming days on its EUR100.3 billion of debt to the TARGET2 system and its EUR90 billion of ELA liabilities.  We would like to think that there is some double-counting here (and at first sight there appears to be some) but even if there is a lot of double-counting within these numbers, given that Greece’s GDP is only EUR190 billion annually, the country is running a current account deficit, and the Greek central bank only has assets of EUR1.7 billion at the ECB, there has to be a very high probability indeed that Greece will end up defaulting on some of its liabilities to the ECB at some point and particularly if it leaves the Euro.   

While we suspect that the ECB / European system could begrudgingly absorb losses from its ELA programme, losses to the TARGET2 system would be another matter altogether.  We can only assume that were the TAREGET2 system to take significant losses, then there would be an ‘intensive discussion’ amongst European governments over whether the losses should be shared according to the ECB’s capital key or whether they would be born almost entirely by the creditors (i.e. whether Germany should suffer merely 20% or 80% of the resulting losses with Luxembourg facing the remainder…).  However, whatever the result of these discussions, we suspect that TARGET2 would thereafter be obliged to gravitate towards a better facsimile of the Fed’s long-standing FEDWIRE system, in that it would have an annual settlement date introduced – a feature that would shift TARGET2 from being a source of infinite credit to debtor countries to one of being a source of automatic deflationary discipline for those countries with deficit positions.  Even if TARGET2 survived a Greek default, we suspect that its subsequent reform would fundamentally shift its character and force the ECB into either accepting more deflation in the deficit countries or becoming more overtly supportive of these economies through the ELA etc.

Greece clearly matters to the Euro System to a much greater extent than either its GDP or other banking systems’ exposure to it might suggest at first sight.  However, we would also suggest that the latest European data has not been all about Greece.  Although the release of latest banking system data was of course overshadowed by events in Greece, and at the same time flattered by the unwinding of a series break within the French data, the fact remains that Europe’s money and credit data has been weakening quite consistently since the ECB introduced its QE.  Although there continues to be some modest growth in bank lending to the household sectors of Germany, France and (just) Italy, we find that lending to the non-financial sector corporate sector is declining once again and that the ECB’s miss-handling of the bond markets has resulted in heavy selling of both corporate and public sector bonds by domestic banks and foreign investors.  This bond selling has done much to negate the impact of the ECB’s bond purchases on the liquidity data, since when a bank or foreigner sells bonds in an economy it will implicitly destroy liquidity in that economy. 

In many ways, we can quite easily understand the increase that has occurred in bond disposals by both domestic banks and foreign investors – after all a similar event occurred in Japan last year which also led to weaker liquidity growth in the real economy – but the slowdown in conventional credit growth is perhaps rather more perplexing.  Our explanation for this event is not so much that credit growth has in fact slowed but rather that the apparent pick up in January was in reality merely a one-time event that had been caused by the (strange) near collapse in CP issuance that month; it seems to us that the increase in bank lending that so excited the markets during Q1 was merely the by-product of a specific issue that occurred within the CP markets earlier this year but which has now been resolved.  

However, this does imply that, far from gaining traction, the ECB’s QE has in fact failed to ignite credit growth but has created more volatility in global currency markets and of course bond markets.  No wonder the BIS felt obliged to be so openly critical of the ECB in its annual report, and the OECD has felt compelled to voice its concerns in private.  All in all, it seems to us that the ECB is facing perhaps the biggest crisis of its existence so far; not only could GREXIT force a major reform of its systems with far-reaching consequences, its flagship QE policy is apparently in urgent need of modification but any ‘modification’ would risk creating further instability in European bond markets. 

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