What a sovereign default would look like on the ECB’s balance sheet
Central banks’ QE programmes have exposed them to sovereign defaults in an unprecedented way. However, the most likely candidate in Europe is likely to do little damage.
Given the centrality that central banks’ intervention in financial markets and in light of the ongoing demands by the IMF that Greece’s Euro-zone creditors accept a debt haircut as the price of returning the country to debt sustainability, it seems pertinent to consider what such an event would look like.
Starting from the case of Greece, and ignoring whether debt relief is really necessary or not, two partial Greek default scenarios are used to illustrate the effect that such an event would have on the ECB. The resulting containment of such a shock is the result of Greece’s relatively small scale as well as the nature of modern fiat currency monetary systems, which endow central banks with flexibility not available to their predecessors as recently as the first half of the 20th century.
Composition of Greek sovereign debt
According to the Greek Finance Ministry, Greece owed € 328.34 billion in debt at the end of June 2016. This is a little over €7 billion more than at the end of December 2015 thanks to the latest ESM loan disbursal in June 17. More importantly, and critically for the country’s debt sustainability, this amount is equivalent to 176.9% of its GDP.
The vast majority of Greek public debt is owed to international official creditors:
- The EFSF and the ESM lent Greece €130.9 billion and €28.9 billion, respectively
- From the IMF, Greece received another €32 billion.
- The majority of the cash for the first Greek bailout, worth €47.1 billion, was provided by European countries through what became known as the Greek Loan Facility (GLF).
- Of the €60 billion in Greek government bonds outstanding, €14.6 billion were held by the ECB at the end of 2015.
- Consolidating the Bank of Greece into the ECB adds another €3.8 billion outstanding in loans provided to the Greek government.
Exposure of the ECB to a Greek default
From these figures, it is possible to estimate that the consolidated and direct exposure of the ECB due to the Greek loans made by the Bank of Greece and the bonds held under the SMP at the end of 2015 amounts to €18 billion. This is a mere 5.6% of Greek Debt Outstanding as of December 2015 or a minuscule 0.065% of the ECB’s balance sheet.
Of the bonds issued by the EFSF and by the ESM, 29.7% are held by the ECB, equivalent to approximately €56 billion. Ignoring for the time being the fact that a Greek default on any of these institutions would be covered by their robust capitalisation, it is also possible to consider the unlikely scenario whereby these losses are passed on to the ECB. As a result, and because there is no information about how much of that 29.7% is made up of EFSF or ESM bonds, it is also worth considering an aggregate scenario whereby a haircut is evenly imposed across both institutions. In this case, the total Greek default cost affecting the ECB would amount to €74 billion or 2.69% of its balance sheet at the end of the third quarter of 2016. Nevertheless, such a default on the EFSF, the ESM, the Bank of Greece and the ECB would represent a debt haircut of as much as 54.15% to Greece. This haircut is consistent with the IMF’s conditions that debt sustainability be restored before its participation in any future assistance is considered.
How would the ECB cope with the default?
The relatively small impact of the default scenarios is patent in the figure below. The ECB’s balance sheet would not even fall below €3 trillion should a Greek default wipe out €18 billion or €74 billion of its assets.
From the several ways in which this could be reflected on the liabilities side of the balance sheet, nothing more creative than the existing reserves and capitalisation funds of the ECB would be necessary to cushion against the effect of this loss.
What about a default is problematic for the ECB?
Because the ECB runs a fiat currency monetary system rather than a commodity-based one, such as a gold-standard one, it can always print its own currency. As the ECB recognises, this means that it can theoretically function with negative equity, which for most businesses would mean bankruptcy.
A modern central bank can default, but only when its liabilities are denominated in foreign currency it cannot print or if they are linked to some other indicator, say inflation, in which case printing currency could trigger a spiral of higher interest payments. But all this is immaterial for the ECB, whose liabilities are mostly denominated in euros and are not linked to inflation.
The most problematic part of a default on the ECB would probably be the distribution of these losses across national central banks (NCBs). This problem was highlighted back in 2008, but interest has been revived recently due to the issues created by the negative yielding bonds purchased under the ECB’s QE programmes and the distribution of the losses inherent to such assets.
The orthodox shocks considered here are the simplest direct cases of an outright and targeted default, supposedly conducted in a planned and orderly manner. A larger (e.g. Italy or Spain) or more spontaneous and generalised default would create a myriad of problems. These would include the lack of liquidity similar to that experienced by Greeks last summer and the possibility of larger losses to the ECB due to contagion to other asset categories and to the collateral it accepts in its funding operations. Such scenarios could force the ECB to consider more innovative approaches such as carrying losses forward, ring-fencing future profits or even actually operating with negative equity, any of which would certainly look very unorthodox.