Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 25 January 2012

Eurozone Snap Comment - 25-Jan-12


The trophy for sheer brilliance in decision making with nary a thought for the consequences goes to...Christine Lagarde for her stupendous decision to ask the ECB to take haircuts. Critics are raving that this is even better than Hank Paulson's performance in pulling the plug on Lehman.

To understand better, let's start with a few calculations. ECB holds 40bn worth of Greek bonds. Assuming it bought them at an average of 80c to the , its capital at risk is 32bn. Paid-up capital of the ECB is 6.36bn (to be increased to 10.76bn by the end of 2012). Risk provision reserve was 5.18bn at the end of 2010 (2011 accounts are yet to be published). Given that general reserves have a ceiling of 100% of ECB's capital this can go upto 6.36bn. Therefore the theoretical maximum amount of principal haircut that the ECB can take is 20 + 12.72/4 *100 = 51.8%. So it can theoretically survive the 50% principal haircut that private bondholders are being asked to take.

So what happens in the event the ECB takes a haircut and survives to tell the tale?
1. Depending on the size of the haircut, ECB will have to call upon national central banks to contribute more capital. NCBs will then have to ask their governments if the cash call reduces their capital ratios beyond an acceptable point. The governments will then have to finance the central banks through their budgets. Governments would increase deficits unless spending is cut commensurately. This would increase debt and worsen debt-GDP ratios. See the problem? In addition, official bickering and comments at various points in the chain will destroy whatever confidence is left.

2. Is the Greek haircut going to set a precedent? Then what happens to the 20bn of Portuguese debt? And 219bn of total SMP holdings? The governing council will realise that further intervention through the SMP is almost guaranteed to lead to losses. SMP stops and that takes out the buyer of last resort. Secondary yields will explode unless political interference forces continuation of the SMP. But this would destroy central bank independence and lead to a collapse of the EUR.

Poor Eurozone.
Cannon to the right of them,
Cannon to the left of them,
Cannon in front of them...

Meanwhile across the Atlantic, Ben Bernanke and his posse (except Lacker) have stared deep into the future and declared that they should continue pushing at a string until 2014. Their unblemished record of forecasting means that the dollar is a sell. Oh wait...are we talking about the same guy who said that the subprime problem is contained? The Fed has provided a great opportunity to re-enter € shorts. Even if the Fed is right and rates have to stay low for longer, is it better to hold a currency which is slowly being debauched or one which may cease to exist at any point? 

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