Sailing into uncharted legal waters

The burden other eurozone states could bear gives them a powerful incentive to keep Greece in the currency club, writes Paul Carrel

A GREEK exit from the eurozone could expose the ECB and the currency bloc it seeks to protect to hundreds of billions of euro in losses, landing Germany and its partners with a crippling bill.

A Greek departure would take Europe into uncharted legal waters. The burden other eurozone states could bear gives them a powerful incentive to keep Greece in the currency club. With most of Greece’s private creditors having taken heavy writedowns as part of the country’s second €130bn bailout, it is estimated that the ECB, IMF, and eurozone nations hold approaching €200bn of its debt.

“In the event of an exit, they [Greece] will default. And the loss given default will probably be very high, high enough to eliminate the ECB’s capital,” said Andrew Bosomworth, senior portfolio manager at asset manager Pimco.

“They might need recapitalisation from governments, who are not exactly in the best position to provide additional capital.”

Those are not the only losses the ECB and its national shareholders might face as is explained in detail below. Once Greece left the currency club, the costs to the rest of the eurozone would mount as it would be compelled to avert a complete Greek collapse and wider contagion.

“Large-scale ECB intervention would be necessary to stabilise the system, along with intervention from Germany, the European Stability Mechanism [ESM], its predecessor the European Financial Stability Facility [EFSF] and the IMF, potentially costing hundreds of billions of euro,” said Georgios Tsapouris, investment strategist at Coutts.

The ECB, which has its own paid-in capital of €6.4bn, is essentially a joint venture between the 17 eurozone national central banks. Combined, the Eurosystem of eurozone central banks has capital and reserves of €86bn. The national central banks would divide up any losses between them according to the “capital key” — the ECB’s measure of countries’ stakes in its financing based on economic size and population. Germany would bear the biggest loss, about 27% of total.

France would take a big hit too. A Greek exit from the eurozone could cost the French taxpayer up to €66.4bn and saddle the country’s banking system with €20bn in lost loans, according to a study published on Tuesday by the IESEG School of Management in Lille.

Smaller countries with less robust national central banks than the German Bundesbank would likely be still harder hit in relative terms.

However, with fresh Greek elections called for June 17 and an anti-bailout leftist party ahead in the polls, some within the EU’s corridors of power wonder whether the show is worth keeping on the road.

“It’s going to hurt, absolutely. But is it going to be lethal?” one EU diplomat asked. “We have two bad choices, but one is worse than the other.”

The ECB and national central banks are exposed to Greece in three main ways: Via Greek sovereign bonds the ECB holds; via Greek collateral they hold in return for ECB loans; and via Greece’s liabilities for transactions over the eurozone’s Target2 inter-banks payments system.

The ECB has spent about €38bn on Greek government debt with a face value of about €50bn.

Under a scenario described in German weekly Der Spiegel, the eurozone’s EFSF bailout fund could be used in the event of a Greek default to continue funding Greece’s debt obligations to the ECB.

However, this would eat into the resources of the “firewall”, eroding its capacity to help other eurozone states which might well need to be protected if a Greek exit sparked contagion.

An alternative scenario could see the national central banks turning to their governments to recapitalise the ECB. But going cap in hand to politicians for money risks undermining the ECB’s independence.

ECB loans to Greek banks are another way the central bank is exposed but, in this case, although the ECB conducts these medium and long-term lending operations (MROs and LTROs), the funds are distributed via the national central banks and carried on their balance sheets.

A Bank of Greece financial statement on its website showed that, as of Jan 31, it had lent out about €15bn in MROs and €58bn in LTROs — a total of €73bn.

It was holding €143bn in assets eligible as collateral for eurozone monetary policy operations.

Berenberg Bank economist Christian Schulz said that, in the event of a Greek exit, these loans and most of the collateral may be converted into a new Greek currency.

“The ECB/Eurosystem would not bear the risk anymore,” he said, noting that the Bank of Greece would instead be left with the — likely devalued — loans and collateral.

But any funds Greek banks had taken using ECB loan operations that had subsequently found their way out of Greece could pose a problem. These would be added to the Bank of Greece’s liabilities under the Target2 payments system.

The Bank of Greece and other peripheral eurozone countries have built up liabilities within the eurozone’s cross-border payment system, Target2, due to a net outflow of payments to other countries in the bloc, a trend exacerbated by the debt crisis.

The Bank of Greece’s financial statement showed that as of January it was carrying Target2 liabilities of €107bn — a sum that has likely remained around that level since and which represents a big potential problem for other eurozone central banks.

“Target2 is the biggest risk if they really take that loss,” said Schulz, adding that a Bank of Greece collapse would leave central banks remaining in the eurozone with a loss.

“But it’s far from clear whether the full Target2 balance would be what Europe would lose,” he added.

The ECB could monetise any net Target2 loss in the event of a Greek euro exit by printing money but that would come with an inflationary effect unpalatable to policymakers in Germany, the bloc’s most powerful player.

Beyond the accounting implications for eurozone central banks is the systemic impact a Greek euro exit would have on the bloc’s banking system. Savers in other peripheral countries are likely to take flight.

“If they see that Greek savers have seen their euro savings overnight being converted into drachma, which could depreciate by 50-70%, then it would be a fairly simple hedge strategy for them to take out some of their savings and put them into Luxembourg, or pounds sterling, or Swiss francs,” said Bosomworth.

Ultimately, Greece will decide whether it leaves the eurozone but the ECB can try to head off such a scenario. “What they can do is try to prevent contagion, where they have a very significant role, and they will probably also try to convince participants on all sides to keep Greece in the euro area,” said Citigroup economist Jürgen Michels.


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