The ECB’s nuclear option has its limitations
Here’s a thought regarding the European liquidity scheme.
My understanding is that the ECB is legally prohibited from ‘monetizing’ Eurozone debt by buying it directly at auction. Therefore, in instituting the nuclear option of buying up debt, they can only do so on the secondary market. I had been thinking of the constraints this imposes operationally when I read this from John Hussman.
The bailout package for Greece should keep it from having to tap the open market for capital for about 18 months. Yet it is hard to look at the possible trajectories of Greek output, deficits and debt without concluding that a debt restructuring will ultimately be necessary – meaning that owners of Greek debt are likely to receive only a portion of face value. What European leaders seem to be attempting is to buy Greece more time, essentially to smooth the potential amount of this restructuring and its impact on the banking system, perhaps three or four years from today when, hopefully, Greece has smaller deficits and the ability to operate without new borrowing.
While this is a hopeful scenario, backward induction is not kind to it. In Game Theory, there’s a technique called "backward induction" that is often used to identify the likely outcome of a game that is repeated again and again for multiple periods. Essentially, you evaluate what would be the best move for each player that would be optimal in the very last period, then assuming those moves, you evaluate what the optimal moves would be in the next-to-last period, and so on to the beginning of the game.
Put yourself in the position of a holder of Greek government debt a few years out, just prior to a probable default. Anticipating a default, you would liquidate the bonds to a level that reflects the likelihood of incomplete recovery. Working backward, and given the anticipated recovery projected by a variety of ratings services and economists, one would require an estimated annual coupon approaching 20% in order to accept the default risk. For European governments and the IMF to accept a yield of only 5% is to implicitly provide the remainder as a non-recourse subsidy. Even then, investors are unlikely to be willing to roll over existing debt when it matures – the May 19th roll-over is the first date Europe hopes to get past using bailout funds. In the event Greece fails to bring its budget significantly into balance, ongoing membership as one of the euro-zone countries implies ongoing subsidies from other countries, many of which are also running substantial deficits. This would eventually be intolerable. If investors are at all forward looking, the window of relief about Greece (and the euro more generally) is likely to be much shorter than 18 months.
This is how I see things as well. I anticipate that we are likely to see busted auctions in the very near future. The May 19th auction for Greek sovereign debt will be a good indication of the demand for Greek debt. The EU’s one trillion dollars is a big figure – well worthy of the shock and awe moniker attached to it. But, when the inevitable debt auction failure does arrive, there are limited funds in the trillion dollars of liquidity committed to directly buying Greek debt (110 billion euros). The ECB cannot monetize the debt by buying it at auction.
So when the 110 billion euros runs out, what then?
Greek Debt and Backward Induction – John Hussman’s Weekly Market Commentary