© The Financial Times Ltd 2015 FT and 'Financial Times' are trademarks of The Financial Times Ltd.
March 24, 2010 4:07 pm
No country would hand the controls of a nuclear device to a third party. But that is, in effect, what the European Central Bank is doing with its repo facility for eurozone sovereign debt.
This facility has proved highly effective in dealing with the crisis. But the ECB’s policy of leaving the decision of eligibility for collateral at the repo facility exclusively to the ratings agencies has created unnecessary uncertainties during the crisis – and the central bank’s policy of charging the same haircut for all sovereign debt has almost certainly provided the wrong incentives during the years leading up to the crisis. These policies desperately need a re-think.
To recap, until the end of this year, eurozone sovereign debt is eligible for the ECB’s repo facility so long as it is rated at least BBB- by both S&P and Fitch, and at least Baa3 by Moody’s. From the beginning of 2011, the threshold moves three notches up for all three agencies. Today, Greece is rated BBB+ by both S&P and Fitch, and A2 by Moody’s. This means that if Greece is not upgraded by either S&P or Fitch before the end of this year, then Moody’s – and Moody’s alone – will decide whether Greek sovereign debt is eligible as collateral at the ECB. All it takes is a two-notch downgrade to bring them in line with the two other agencies and Greek sovereign debt would no longer be eligible as collateral at the ECB come 2011.
This is broadly equivalent to placing a nuclear device in the hands of Moody’s because there can be little doubt that were Greece to lose eligibility at the ECB, this would imply an immediate collapse of the Greek financial system, almost certainly a sovereign default, and severe stress throughout eurozone financial markets. This is so scary – and the fact that the decision sits with Moody’s makes it so unbelievable – that few people in the market think it is realistic. But how the ECB would react to a downgrade by Moody’s nobody knows.
Entrusting decisions with such consequences to ratings agencies is inappropriate. Assessment of creditworthiness is tricky at the best of times, and I certainly do not want to throw stones given that I myself live in a glass house. But, in most cases, ratings are difficult to reconcile with economic developments. For example, Moody’s now rates Greece at the same level of risk (A2) as it did in 1999, when the deficit was a quarter of today’s and its debt some 20 per cent of GDP lower than it is currently. Also, in the intermediate years, Greek unit labour costs have risen 30 to 40 per cent faster than in Germany, putting pressure on competitiveness and future growth. Moody’s did reward Greece with a one-notch upgrade after it adopted the euro, a rating it kept – in spite of deficits and debt accumulation – until December last year; several months after the Greek government revealed that the 2009 deficit was double the previous estimate. Moreover, less than two years ago, Moody’s rated Iceland A1 (one notch above Greece’s present rating), and while it has since downgraded Iceland by five notches, the country is still “investment grade”. Clearly, the ratings agencies, not just Moody’s, are lagging indicators, at least compared with the market.
To establish credibility – and to provide the right incentives – the ECB urgently needs to change its collateral policy in two respects. First, the present non-credible nuclear threat of losing eligibility altogether needs to be replaced with a credible “conventional army” option that imposes incremental pain on fiscal sinners, but would never push a sovereign member of the euro-system over the edge of the cliff. Specifically, the ECB should introduce a sliding scale of increasing haircuts, ranging from small ones to very punitive ones for sovereigns with serious creditworthiness issues. Second, that sliding scale of haircuts should be determined by a broad set of measures with the rating agencies being only a complement to a more facts based assessment. Specifically, the scale determining the size of haircuts should be a combined average of the three leading agencies and the ECB’s own assessment, based on a transparent set of objective quantitative indicators. Such indicators should cover both structural and cyclical measures of government deficit and debt ratios. Weighting them all together with the average ratings would then produce one key index number, which could be pared back with a haircut.
This system would be better than the present one for two reasons. First, it would be credible because there would be no “cliff” over which an agency could theoretically push a sovereign eurozone member. Second, the ECB would no longer encourage abnormally low spreads in “normal times” because of the uniform spreads across all sovereigns; an anomaly which probably contributed to too narrow spreads in the good years, and hence possibly to too lax fiscal policies.
Erik Nielsen is Chief European Economist at Goldman Sachs
Copyright The Financial Times Limited 2015. You may share using our article tools.
Please don't cut articles from FT.com and redistribute by email or post to the web.
Sign up for email briefings to stay up to date on topics you are interested in