The end of constructive ambiguity, Mr Trichet?

Buttonwood

Nov 22nd 2005
From The Economist Global Agenda

Bond markets barely reacted to the European Central Bank’s recent signal on sovereign debt ratings. Odd, that

MARKETS have short memories. Of catastrophic events in the euro area, they have none at all: the past six years, all things considered, have been pretty benign. The closest approximation is probably the fading recollection of the explosion of the euro’s forerunner, the Exchange Rate Mechanism, in September 1992. As British ministers huddled around a radio—their only source of news in a temporary office—George Soros and others copped something like $1 billion driving sterling (and the lira) out of the system.

Maybe this lack of memory of market-jolting turbulence explains why, when Jean-Claude Trichet, president of the European Central Bank, dropped some new, could-be devastating information earlier this month, the market for European government bonds moved only a little. In effect, Mr Trichet made it clear that if the rating agencies took too dim a view of European Union governments’ bonds, the ECB would not accept them as collateral in refinancing (repo) operations. One respected analyst called this a “potential nuclear bomb”. That may tend towards hyperbole; but even so, it seems that the market failed to grasp what Mr Trichet said, and still hasn’t got it.

It isn’t the first time that markets have been slow to spot danger. More than a decade ago, analysts started musing that General Motors had unfunded pension liabilities that could one day push it into bankruptcy. For the traders of the day, though, it wasn’t going to happen; and if it ever looked likely, there would be plenty of time to dump their GM bonds and shares. Well, we all know what’s happened to the prices of those bonds and shares since; and quite a few investors, some sophisticated ones among them, were caught out when trouble came.

Beware the grim repo

On the face of it, Mr Trichet simply clarified a detail about the ECB's criteria for accepting EU government bonds as collateral. Any bond rated below A- by all three of the big rating agencies would be turned down, he said. At the moment, none is rated lower than Greece, at A, which still leaves the cradle of democracy two notches from ignominy. So an exclusion from the ECB’s repo is for the moment merely hypothetical.

But he who does not hypothesise is a bad trader and a bad risk manager. Suppose Greece were downgraded two notches. What would happen? Banks holding Greek government bonds, either physically or as collateral, would no longer be able to use them to refinance themselves with the ECB, their lender of last resort, as they do with euro-denominated bonds to the tune of around €250 billion ($293 billion) at every weekly tender. That would make Greek government bonds much less useful as collateral and less liquid. So their price would fall. The Greek government would be clobbered by a double whammy—a sharp increase in its financing costs and rejection by potential lenders—just when it was hit by a downgrade.

It is improbable that Mr Trichet thinks this at all likely. Maybe he simply wanted to send a shot across the bows of spendthrift governments—not only Greece, but Portugal and Italy, too. All three once qualified for the euro by reducing their government debt to 60% of GDP and their budget deficits to 3%—or by promising to do so. None, though, has proved capable of meeting similar criteria in the euro zone’s stability and growth pact.

The ECB’s repo mechanism accepts all euro-zone government bonds (and British ones, if they are in euros) indiscriminately: Greek and Portuguese government bonds are treated with the same respect as German Bunds and French OATs. The market has hitherto seemed to take this as a signal that the ECB regards all in the euro zone as equally creditworthy, and has treated the zone as a single sovereign area in which all stand and fall together. The spread between the highest- and lowest-yielding ten-year bonds has rarely exceeded more than 30 basis points in the past couple of years.

Yet it is perfectly clear that Standard & Poor’s, Moody’s and Fitch, the top rating agencies, have a different view. Their ratings signal the probability of default and say, quite reasonably, that Greece, rated A, is a riskier credit than Germany, at AAA. The Maastricht treaty, in similar vein, declares that countries that mess up their finances will not be bailed out.

Mr Trichet's remarks have made it clear that not all euro-zone countries are necessarily equal. In theory, a country in the zone could go bust. Whether the ECB or other euro-zone governments would let that happen is another matter. But if they bailed out a failing government, they would be flouting the Maastricht treaty and risking a serious dent in the credibility of the euro.

This is not an easy path for the ECB to tread. Rather than spelling things out as he did, Mr Trichet may have done better to keep people guessing—a practice known in the trade as constructive ambiguity. (He abandoned constructive ambiguity again last week when he strongly signalled the ECB’s first increase in interest rates for five years and its first move in either direction for two and a half.) However, as the ECB hastens to point out, anyone trawling through the weekly list of securities eligible for repo, published on its website, would have discovered that not one of them is rated lower than A-, and that has always been so.

What might the ECB do now that it has spoken plainly? It could, perhaps, move its criteria gradually away from the ratings of the three agencies to its own assessments. Perhaps there is nothing more to be done. The market, after all, has heard what it said—and ignored it. The spreads of Greek, Portuguese and Italian bonds over Bunds have moved only marginally.
Traders say that some investors have shed a few of these lesser-rated euro-zone bonds. But few, if any, appear to have taken seriously the worst-case scenario. For those who do change their mind, it is only a matter of time before investment banks design credit derivatives that will pay out if any country slips off the ECB’s approved list. You read it here first.

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