The ECB’s statement in early November to the financial markets regarding the eligibility of repo collateral of sovereign debt has caused some heated discussion in the higher echelons of European finance policy makers, especially those in Portugal, Italy and Greece.
In answer to a question at a press conference ECB governor Jean-Claude Trichet said that the ECB would not accept collateral with a rating lower than A–. Currently only Greece is anywhere near this level (A). This change brought the ECB’s policy in line with regulators in the UK, Sweden and Switzerland. However the ECB is the central bank not of a nation state but of a new political union. The timing of its announcement resulted in the issue price of a five-year bond from Portugal widening by 1bp from 10bp over treasuries on the $3billion deal. That cost Portuguese tax payers some €900,000 extra upfront.
What game is the ECB playing? Until this clarification, the bond markets had assumed that the ECB would apply the same rules to all eurozone sovereign debt, regardless of rating. While the ECB takes liquidity into account in discounting bonds for repo, it does not look at credit.
This move appears to be designed to encourage certain countries to work on correcting fiscal imbalances before their public finances get out of hand. Senior debt officials in Europe suggest that the ECB wanted to remind all parties that there is no possibility of bail-out in the euro zone. Getting stuck with lots of cheap bonds itself might have made it difficult for the ECB to resist calls for a bailout. Now it is discriminating on credit quality, the issue doesn’t arise.
Lack of political action on the stipulations of the Growth and Stability Pact over annual deficits and total debt to GDP is a factor. But the countries with the weakest ratings (Greece, Italy and then Portugal) are not the only ones at fault. France and Germany are both in breach of the rule limiting the annual budget deficit to a ratio of 3% of GDP.
The ECB could even be placing the euro project at greater risk by directly encouraging bond market divergence and aggravating certain EU governments.
In the US, it would be inconceivable for the Fed to say something similar about California’s finances, despite that state’s economic woes.
The risk of discord between European politicians and monetary policy makers will rise further if the ECB hikes euro zone interest rates, as Trichet appeared to signal in November. Perhaps the ECB has its reasons for trying to encourage the financial markets to discriminate against the likes of Greece and Italy, but it’s a dangerous game.