Over the past few weeks, market speculation about the public finances of some countries at the southern periphery of Europe has reached a fever pitch.
Not since the currency crises of the early 1990s has there been this much concern in financial markets about the ability of a European government (Greece) to roll over its existing debt and finance its budget deficit. Although there has so far not been any hard evidence to substantiate these concerns, we note that (il)liquidity is, by its very nature, based on confidence and can therefore be self-fulfilling.
We still believe that financing conditions could change positively if Greece achieves the flawless implementation of the fiscal adjustment that it has promised EU authorities. Under an extreme – and currently hypothetical – scenario, in which access to market funding was closed to a government at any price, we believe that the balance of costs, risks and benefits would lean unequivocally in favour of liquidity support being provided in some form by the EU.
However, we doubt that such support would be unconditional or extended indefinitely, and instead believe that support would be conditional on fiscal adjustment taking place without slippage.
In the event that Greece’s implementation of the promised fiscal adjustment fails to meet the conditions for its partners to provide a backstop liquidity protection – i.e. if public finances remain on an unsustainable path – then we might consider revising our assessment of Greece’s liquidity risk, which could lead to a risk of a multi-notch downward rating migration. But this is not an immediate concern.
We see liquidity risk to be negligible in the case of Portugal and even more so in the case of Spain, both of whose situations are in our view not directly comparable to that of Greece.
Overstated Liquidity Risk
It is worth remembering that there is, as yet, no hard evidence that any euro area government faces an imminent risk of losing market access.
The five-year bond issued by Greece in late January was substantially oversubscribed, and the country’s debt agency ended up issuing €8 billion instead of the planned €3-€5 billion, albeit at the cost of a large widening of yield spreads relative to other European sovereign issuers.
Therefore, speculation that Greece, or any other government, might not be able to roll over existing debt falling due in the spring has so far been based on perception rather than fact.
Even so, in the event that a critical mass of investors starts believing that a government's liquidity is impaired, this could become a self-fulfilling prophecy. Moreover, if enough investors believed that a government's debt is on an unsustainable path, it is unlikely that they would be willing to purchase bonds except at a very high price (which could by itself put the debt on an unsustainable path). In such a situation, a credible alternative source of liquidity would allow a country to fend off financing and ultimately potential payment difficulties, until it regains the trust of commercial markets.
Against this background, much attention has been focused on the possibility that emergency liquidity assistance could be extended by the EU or some of its more robust members to one or more of its weaker members if they encountered temporary liquidity or pricing hurdles.
On balance, we believe there is a very high likelihood that such support would materialize if required, although it would be neither unconditional nor permanent. Statements by EU officials have reflected ambiguous attitudes towards the notion of support towards a member state: acknowledging European solidarity on one hand, whole pointing to the dangers of moral hazard for the stability of the Union on the other.
Incentives and Disincentives
There are both incentives and disincentives for the provision of liquidity support across the euro area. Indeed, combined, these factors represent an important component in our rating analysis for EU countries, and have so far prevented any member country from being rated at non-investment-grade levels.
Taking the disincentives first, the risk is that liquidity assistance turns into an ongoing fiscal transfer, or is perceived as one. This would generate moral hazard, but it would also cast a deeper shadow on the framework of fiscal responsibility (the Stability and Growth Pact) that has amply demonstrated its shortcomings and is already well dented. Anyway, a permanent transfer of this kind outside the normal channels is never likely to win support from taxpayers in potential donor/creditor countries as they are not likely to take kindly to being asked to compensate for the profligacy of others.
There also exist, however, powerful incentives to intervene. The first of these is the risk of contagion, which is effectively already materializing. As mentioned already, this situation is reminiscent of the contagion that prevailed at the times of ERM currency crises in the early 1990s. It speaks to a de facto solidarity that arises between European governments.
It is difficult to imagine that the governments that extended widespread support to their banks in order to contain contagion risks, and that provided support to Latvia or Hungary for more or less similar reasons, would withhold liquidity support to a fellow EMU member state, given the risk that this may generate to their own funding plans and costs. This is especially true if the member state in question is actively pursuing a responsible fiscal reform strategy, even if belatedly so.
In addition, it is in the interest of the EU that member states put public finances on a clearly sustainable path. This cannot happen if (i) their cost of funding spirals uncontrollably or (ii) they cannot fund their borrowing requirement during the adjustment process.
In sum, the balance of costs, risks and benefits appears considerably skewed in favour of the EU and its more robust member states providing, if required, emergency liquidity assistance to the more exposed governments.
Possible Support Mechanisms
The Treaties that helped to create the EU foresee in various articles the possibility for the Union or its members to grant assistance to others. This does not mean that assistance has to take place through one of the schemes that are explicitly mentioned, some of which have restrictions that may not apply in the current context. Governments are sovereign, and the assistance they grant each other is – in the ultimate analysis – a sovereign decision.
Moreover, Article 308 of the Lisbon Treaty states: “If action by the Community should prove necessary, within the framework of the policies defined in the Treaties, to attain one of the objectives set out in the Treaties, and the Treaties have not provided for the necessary powers, the Council, acting unanimously on a proposal from the Commission and after obtaining consent from the European Parliament, shall adopt the appropriate measures.” This article makes explicit that the EU has broad flexibility to do almost anything that it has not been explicitly prohibited from doing.
The EU Treaties only contain two explicit prohibitions: one stipulating that the EU or a member state cannot be held liable for the debt of another, and another that prevents central banks from lending directly to, or purchasing bonds directly from, member governments.
Neither of these is an obstacle to liquidity support, which could take several forms, both direct and indirect. Direct support would involve the EU or individual member states granting loans to another member state. Indirect support could take the form, for instance, of requiring an EU agency – such as the European Investment Bank – to provide budgetary support loans to member states. (Note that the African Development Bank did make budget support loans available to its member governments during the crisis.) While the EIB has ruled out such a move, its shareholders may have different views.
It is somewhat less likely in our view that central banks would step in and purchase government bonds in the secondary market. Still, the mere fact that government bonds remain eligible as collateral in Eurosystem operations will facilitate the refinancing of Greek and other government debt, under the condition that Eurozone banks have the balance sheet capacity to purchase these bonds and refinance them at the central bank.
These points lead us to conclude that EU member countries and institutions have the flexibility to provide back-up liquidity assistance should this be needed under the rules of the Treaties. The immediate reason for such intervention is that not doing so would spill over to other countries and raise their cost of financing.
Nonetheless, we expect that any such support will be laced with strict conditions. To the extent that the European Commission felt unable to impose strict conditions on a member state for its support, an option would be to subordinate the country to IMF assistance (which any member is entitled to request). While clearly an unappealing option to all parties involved, this would be more palatable than either of the alternatives: i.e. unconditional EU support or no support.
It is important to acknowledge that there are legitimate concerns about Greece’s public finances in light of the high level of government debt and deficits, the repeated deception practiced by officials in reporting on the country’s public finances, and successive authorities’ broken reform promises. All of these issues pose serious impediments for regaining market confidence, but it is the latter that is the most relevant at this juncture. Oversight by the European Commission as well as continuous scrutiny by Eurostat is expected to deal with the immediate issue of the statistical deficiencies, although we will follow their monthly assessments closely.
Greece’s Stability and Growth Programme: Key Elements
Overall, we believe that the Greek government's medium-term fiscal plan is relatively well designed. The Stability and Growth Programme announced last month aims to partly overcome the country’s formidable and longstanding fiscal problems, such as endemic tax evasion and lax enforcement.
An initial effort was made to compress the public sector wage bill by cutting allowances and removing their favourable tax treatment, and the Greek authorities have acquiesced to European Commission demands to do even more on the wage front. Just as importantly, the government has obtained unprecedented cross-party support (excluding the far left) for the measures, and has committed to making additional adjustments as needed to compensate for revenue shortfalls.
But the spread between nominal GDP growth and interest rates will work against the debt dynamics in the next couple of years, even if the government is able to implement its ambitious plans. The planned higher revenue generation and cuts to public sector wages will also probably have a negative impact on economic growth to a degree that may have been underestimated by the government.
Greece needs to issue a very large amount of debt – roughly €40 billion – to cover upcoming amortizations as well as its budget deficit in the first half of 2010. Around a quarter of this amount has already been raised.
It is important to put this amount into context and point out that it is a tiny fraction of the amount of debt raised on a monthly basis by European countries and institutions, although it is large relative to Greece’s own economy. As mentioned previously, however, investors are currently more sceptical about the country’s short-term fiscal situation and are requiring the government to pay relatively high interest rates as a consequence.
How Can Greece Win Back Investors’ Trust?
Faced with situations where markets overshoot, governments also need to overshoot in terms of ambition and execution. Should Greece follow through on the consolidation plan that it solemnly announced last month, it may be able to create a virtuous dynamic. The more rigorously it complies with the ambitious program, the more quickly market conditions will return to a semblance of normality, although not to the buoyancy that characterized them prior to the crisis.
There is an enormous amount of legislation that the Greek government has promised to enact in the first quarter of 2010. When and if the key pieces of legislation, such as tax and pension reform, have been passed into law, they will provide a meaningful signal as to how far-reaching structural reform is likely to be and, ultimately, where the Greek government ratings will end up.
Of course, the previous absence of political will to undertake and then maintain reform means that there is no certainty that the Greek authorities will be able to sustain the effort on this occasion. However, they have more incentive to do so at this point than at any time since the late 1980s.
Overall, we believe that the long-term success of the Greek fiscal consolidation effort – and ultimately how Greece is likely to be rated in five years’ time – depends on three factors:
- credible implementation of the programme;
- overcoming the electorate's longstanding resistance to structural economic reform; and
- regaining the trust of Greece’s European partners and EU institutions and, crucially, the financial markets.
About the Author
This article is an abridged version of "Spain, Portugal & Greece: Confusion or Contagion?", a special comment by Moody's Investors Service released in February 2010.