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Analysis
The big loser from Euro wrangling is EMU’s overall credibility

The big loser from Euro wrangling is EMU’s overall credibility

by David Marsh

Mon 13 Jun 2011

The German government and the European Central Bank realise that the big loser from the skirmishing over the euro’s future will be overall public trust in the European monetary project.

Nerves and tempers are fraying in Berlin and Frankfurt over conditions applied by the German parliament last Friday for new loans to Greece. Wolfgang Schäuble, finance minister, insists that making private sector creditors share in the cost of a new financing package for Greece is the only way of securing political backing for fresh bail-out loans.

On the other hand, the European Central Bank – given powerful backing by Germany’s Bundesbank – is digging in its heels by stating that almost any form of restructuring of Greek private sector debt would trigger default clauses affecting all of the country’s borrowing. This is on the grounds that a so-called ‘voluntary restructuring’ would not be seen as such by the majority of creditors – a position that has already been clearly stated by credit rating agencies.

This kind of ‘selective default’ would then very likely spread to the other most heavily indebted countries, Portugal and Ireland, as well as possibly to Italy and Spain too, officials say. A negative spiral would ensue. The ECB’s rules forbid bonds from countries that are formally in default being used as collateral in the ECB’s financing operations with banks – which would then bring Europe’s financial house of cards tumbling down.

Jens Weidmann, the Bundesbank’s new president, intensified the hard line in a weekend interview with the German newspaper Die Welt. He pointedly refused any further central banking help for Greece, including through a maturity extension of Greek bonds held by the ECB and national central banks. He acknowledged that the ECB’s policy might drive the Greek state into insolvency, which he said would have ‘dramatic economic consequences’. But he said this was a decision that would be made above all by the Greek government and population. Whatever happened to Greece, the euro would remain a stable currency, he affirmed.

Central bank officials say the reasons for their objections to debt restructuring go well beyond the risks to the ECB’s own balance sheet, where it is heavily exposed as a result of €75bn euros worth of weaker-country bond purchases since last May (which have been now stopped over the past 10 weeks). Central bankers charge that politicians who put forward ‘soft restructuring’ as the least bad option to solve the sovereign debt imbroglio simply do not understand the basic facts of life of the capital markets.

The ECB knows, however, that governments ultimately can find ways of telling the ECB what to do – whatever monetary union’s founding treaties say about the ECB’s independence.

This is where the issue of credibility comes in. The ECB has already been heavily battered in the eyes of public opinion, especially in Germany, as the result of former Bundesbank head Axel Weber’s spectacular withdrawal in February from the race for the ECB presidency. The Frankfurt-based institution now faces further damage on three fronts.

By modifying its line on restructuring, the ECB looks likely to commit another U-turn in what has been a series of policy reversals on issues connected with the quality of its balance sheet and the collateral it accepts for financing. It is likely to emerge worsted in a very public spat with governments – a brutal contrast with the Bundesbank’s hard-won reputation for independence that was supposed to be one of the prime characteristics transferred to the ECB when it was set up in 1998. And, in view of the additional strains on the balance sheet that will be crystallised by any default, the ECB seems likely to go cap-in-hand to European finance ministries for a much bigger recapitalisation than the doubling of its capital decided last December. At a time when it has been beseeching governments to get tough on their budgets, the last thing the ECB wants to do is to beg finance ministers for more money. But this will be just one of the unpleasant duties that Jean-Claude Trichet, president until end-October, looks like bequeathing to his likely successor Mario Draghi of the Banca d’Italia.

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