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Central Bank Drift: Eupdate Extra

posted by Anna Gelpern

Now that everyone agrees that Greece will engage in a figleaf operation to extend maturities without inflicting net present value losses on its creditors, it is worth mulling the institutional implications of any such operation. If a debt exchange takes place as rumored, I am most worried about two things: the cost to Greece of paying higher interest rates to kick the can down the road, and the costs to the international financial system of getting central banks formally involved in a debt restructuring (re-profiling, re-coloring, whatever). The Greece piece is a replay of the Latin American debt crisis of the 1980s: Greek debt stock and borrowing costs grow as uncertainty lingers, while its creditors build up a capital cushion to face up to reality. The central bank piece is more complicated, and perhaps more broadly important. It is the subject of today's Eupdate.

In financial crises, central banks often load up on "illiquid" securities before fiscal authorities reach political capacity for debt reduction and loss distribution. Such central bank actions are publicly characterized as monetary policy or Lender of Last Resort operations, but are often quasi-fiscal: temporizing while the political system gets ready for crisis response.  (Remember TARP?)

As a result of its crisis operations, the ECB has come to hold lots of Greek debt.  Some of it has migrated back to the Greek central bank. In addition to special operations, some national central banks hold Greek debt as part of their Euro hard-currency reserves. If Greece restructures, the ECB and national central banks have two choices:  participate alongside other creditors, or sit out.  This decision is consequential for two reasons:  first, because it makes explicit the fiscal essence of central bank purchases of government debt, and second, because it implicitly establishes central banks' priority among other creditors to the distressed sovereign.  If central banks exchange their Greek bonds, they are from now on pari passu with commercial banks, hedge funds, and others--and junior to international financial institutions, and the future European Stability Mechanism (ESM). If central banks sit out, they are presumptively preferred, which leaves a bigger haircut for private creditors (and the governments that must recapitalize the insured among them).

My quaint gut view is that central banks should stay out of the sovereign restructuring melee, absent a serious policy debate of how making their fiscal role explicit affects their monetary policy function and all the rest. This decision should not be a by-product of a panicked mid-course correction for Greece, nor should Greece be its accidental victim. Keeping central banks out at the expense of Greek debt sustainability--or even at the expense of other creditors--strikes me as perverse.

What is to be done?  Central banks should swap their Greek debt holdings with the temporary European crisis response mechanism, which should then go to town and restructure while it can, before the permanent preferred ESM comes into being. This will have the added virtue of a politically accountable fiscal answer to a fiscal problem, and of cleaning the slate so the ESM preference is even vaguely credible. But as Wolfgang Munchau points out, political accountability is precisely why this will not happen.

As an aside, it is important to distinguish the matter of central banks taking losses from that of central banks participating in a multi-creditor restructuring.  Central banks can and do take losses just like anyone else holding a securities portfolio.  Central banks have also restructured unilaterally (recall the Fed changing the terms of AIG's support package, extended through a special purpose vehicle). This is different from participating in a general restructuring, even one that is NPV-neutral.


In your second sentence, what do "re-profiling" and "re-coloring" mean?

Reprofiling is unilaterally extending maturities at the same interest rate. If Greece had a 5-year bond paying 5% interest, the bond would become, for example, a 20-year bond paying 5% interest. You have in effect extended the maturity of the debt. I believe that this would precipitate a "credit event" for holders of CDS protection. But many have disagree with me.

If you can wave a magic wand to extend maturity, you can wave a magic wand to declare it not a credit event.

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