ECB Preview: Watch Greece and Spain

The ECB is not likely to cut interest rates at Thursday’s council meeting. The focus, as is often the case, will be on the press conference. Here two countries will likely dominate the discussion Greece and Spain. 

In recent weeks there seems to be greater disagreement among the Troika on how to address the obviously unsustainable Greek debt burden.

The IMF says the official sector should take a haircut, but not it. The ECB refuses to, citing legal constraints, as a loss could be seen as a subsidy/transfer to Greece. That leaves the EU and individual countries, but Germany is steadfastly opposed to any official sector losses.

Draghi may be queried on the ECB’s willingness to forgo profits or allow Greece to buy them back at cost or some other scheme to reduce Greece’s debt burden. Hopefully a reporter will ask about the ECB’s willingness to accept more Greek T-bills as collateral, if needed, until the Troika report. 

After dying down in Q3, the topic of a Greek exit has resurfaced recently. It is not the only place. There has been a thoughtful (even if not ultimately persuasive) op-ed in the Financial Times advocating a German exit. The head of what appears to be the second largest party in Italy (5-Star) has questioned whether Italy can afford to remain in EMU and advocated a referendum on the issue. Redemonination risk is like toothpaste squeezed out of the tube: once out, it is difficult to push it back in.

Separately, Spain’s dilemma is likely to be addressed. Senior Spanish officials continue to press for more details about conditions. A subtle shift has taken place. These conditions initially referred to the terms of the aid—the kind of policies and other adjustments as the necessary conditions for the assistance—but now refer to the kind of commitment from the ECB. 

ECB officials are clear. They do not want to eliminate the spread or premium that Spain pays over Germany. Part of the premium reflects country specific risks and serves as the necessary pressure to ensure officials regain investor confidence. Spain’s Rajoy is not yet convinced that the ECB would push rates much lower than prevailing rates. 

The announcement effect was worth some 250 bp at the 10-year sector and 400-435 bp in the 2-year sector. Spain pays about 425 bp more than Germany for 10-year money. This is down from a peak of near 570 bp. The nominal premium may be flattered by the 150 bp by inflation differentials. Shortly before the ECB meeting, Spain will be selling a new 5-year benchmark bond. This is the longest maturity it is issuing for nearly 18 months. Its reception may be more important than the ECB meeting itself.