This week has seen an escalation in the conflict between the new Syriza government and representatives of the Troika, with the meeting of Prof Varoufakis and Mr. Dijsselbloem yesterday not having gone particularly well. The result is domestic and international panic about a breakdown of relations leading to Grexit. Before considering apocalyptic scenarios, let us revisit the ability of the Eurosystem to shut Greece out if politicians fail to secure some compromise on continued funding.
What if payments from the loan facility cease? Besides funding financial outflows, loans from the EU/IMF and/or the EFSF also help to finance the Greek government. But if these loans cease, there is another avenue by which the Greek government can continue to finance its deficits: it can resort to borrowing more from its commercial banks (a scenario discussed by Garber, 2010). Indeed, although the Greek government is unable to raise long-term funding on the bond markets, it increased its borrowing by means of short-term treasury bills by €22.8bn in the year to June 2011.
The Greek government is able to borrow from its banks because those banks can borrow from the BoG and, in turn, the BoG can borrow from the ECB so long as Greece remains in the euro. The banks themselves would be in no position to object to taking on more government debt, especially if their existing holdings of government debt are written down and this leads to larger state ownership.
The ending of EU/IMF lending to Greece would therefore not be a binding constraint on its government budget or its foreign borrowing. It would be as if Greece had obtained ‘bailout’ lending from the loan facility or EFSF after all. Hence, if EU/IMF loans cease, as is repeatedly threatened, this will cause a faster rise in eurosystem debt.
Although the ECB would not condone an increase in backdoor funding of the Greek government via the eurosystem, there is little that it could do. It could make it hard for the BoG to refinance its banks, by ruling that Greek government debt is no longer eligible as collateral. Such a prohibition would presumably extend to assets that have gained eligibility by means of a Greek government guarantee. Making Greek government debt ineligible would also cause difficulties for other NCBs that are holding it as security for refinancing their banks. But then the BoG could extend its use of Emergency Liquidity Assistance which is not subject to ECB collateral rules.
Although ELA is supposed to be for short periods, the Irish central bank has been using it for the past 2 years and is currently lending some €50bn to its banks via this route. The ECB Council could order the BoG to cease ELA, but this seems unlikely given the Irish precedent. If the ECB did prohibit ELA, depriving the BoG of any approved means of lending to its banks, the BoG would have no option other than to defy the ECB and continue to lend anyway, given the consequence of not doing do: the closure of its banks for the want of liquidity.
The only way for the ECB to stop this indirect eurosystem lending to the Greek government would be by ordering other NCBs to refuse further credit to the BoG, shutting the BoG out of the TARGET2 system. This scenario is considered by Boone and Johnson (2011) who make comparisons with the breakup of the post-USSR ruble zone. But this would prevent clearance of cross-border payments out of Greece and amount to the expulsion of Greece from the euro. The free flow of credit between Eurozone NCBs is an essential feature of monetary union. It is what keeps a euro in a Greek bank equal to a euro in banks elsewhere. As long as Greece remains in the euro, it cannot be excluded from eurosystem credit, so Germany an any other euro countries that still have sound finances will keep lending, whether or not the Greek government defaults. If this is not done via an official loan facility, it will go through the eurosystem (ECB), and it will increase if uncertainty about Greece remaining in the euro accelerates the flight of capital. The ECB cannot avoid continued lending to Greece or any other troubled country that remains in the euro. The ECB (or, more accurately, its owners, the NCBs that constitute the eurosystem) is the lender of last resort whether it likes it or not. If it were prepared to play this role more explicitly, this would do much to help confidence in peripheral sovereign debts.