Wednesday, October 24, 2012

European Officials as the Source of Convertibility Risk

ECB President Mario Draghi identified convertibility risk as the source of increasing yields in Spain and noted the ECB's mandate and determination to address it since there should be no convertibility risk in the euro.  Under the relevant treaties, membership in the EMU ranges from "irrevocable" to "irreversible".    Nevertheless, the risk of a euro exit by Spain concerned depositors and investors in Spain.  What explains this?

In early May, there was a spate of remarks by European officials that could have affected perceptions of the irrevocability of the euro:
  • On May 8, in the wake of the first round of Greek elections, ECB Governing Council member Jorg Asmussen threatened: "Greece needs to be aware that there are no alternatives to the agreed bailout program, if it wants to stay in the euro zone."
  • On May 10, similar comments followed from European Council President Van Rompuy and European Commission President Barroso (EU Turns the Screw on Athens...).  
  • On May 11, in response to a question of whether Greece could be forced from the EMU, Barroso amplified: "Look, if a member of a club, I don't want to talk about a particular country, but if a member of a club does not respect the rules, it's better that it leaves the club...."
  • At the May 14 Eurogroup meeting, Eurogroup head Jean-Claude Juncker warned his colleague Greek Finance Minister Filippos Sachinidis: "If we now held a secret vote about Greece staying in the euro zone…there would be an overwhelming majority against it."
That these comments came from European officials was surprising, as they are creatures of the collection of treaties that make the euro irrevocable.

A measure of the interest of Spaniards in this topic is the frequency of searches from Spain in Google for "exit from the euro" without mentioning Greece and "open an account in Switzerland".  (We recognize that the share of population that does these searches is small.)  This graph overlays these measures on a chart of the 2-year yield spread between Spain and Germany:

People had discussed Greece's departure before Asmussen’s speech, but the idea that the ECB and EU officials could cause it was new.  Depositors and investors in Spain, already concerned by bank solvency, may have thought that this casual treatment of euro membership could apply to Spain as well.

Draghi attempted to repair the damage  on May 16:
"While the ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet, I want to state that our strong preference is that Greece will continue to stay in the euro area."
This failed to stop the rise in Spanish yields.   ECB changed "strong preference" to "immutable preferencetwo days later, with little effect.  It's difficult to counter effectively what appeared to be the broad-based view of EU officials.

A further round of stress in Spain began during the week of July 16, when news that the Troika would be inflexible in its upcoming visit to Greece reignited concern over Greece's ejection.  This began with a leak of a draft Troika report describing the "awful" situation in Greece. Reports of the Troika's inflexibility grew during the week.  This culminated over the weekend of July 21 when three senior German government ministers said there would be no flexibility and suggested that Greece should leave the euro.

On July 26, Mario Draghi indicated that the ECB would "do what it takes", which became the OMT program to buy bonds of countries with convertibility risk premia.  Draghi's dramatic move was intended to respond to a crisis perhaps triggered by his own contemporaries.


Preview of Forthcoming Post: 

Convertibility risk isn't the only cost of a Greek departure.  Presumably unconsidered by the officials who spoke of Greece's departure was the effect on the ECB's balance sheet.  Given the ECB's exposure to Greece through Target2 of about €120bn, a loss of that would have left the ECB with negative equity of about €-100bn, not counting any SMP losses.  (The ECB's exposure to Greece is not collateralized.)  Since the provisions of the treaty ( PSESCBECB Articles 10.3, 28.1, 32.4, 33.2, and Council Regulation 1009/2000) require a  weighted 2/3 vote to go beyond modest recapitalization or loss sharing in the event of a large ECB loss, the ECB could be stuck with negative capital.  This would be awkward at best. 

1 comment:

  1. Will, good analysis. And now that Draghi has addressed the problem by fully committing to convertibility, Target2 imbalances have been declining since September.