Economic Focus -- From Action Economics February 25, 2010, 10:16PM EST

Greece: A Game of 'Chicken' with the ECB?

Some traders think the country could force the ECB to soften its stance on austerity measures and possible financial aid by delaying a bond sale, says Action Economics

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If Moody's Investors Service follows other rating agencies in downgrading Greece's debt, the nation could be in the position that its government debt may no longer be eligible as collateral in European Central Bank refinancing operations. Moody's warned on Feb.25 that "if in a few months it appears there are significant deviations from the plan [to reduce Greece's deficit], then it is pretty likely that we would adjust the rating accordingly." Such a departure could lead to a cut of "a couple of notches" from its current A2 designation.

This would mean that neither Greek nor other eurozone banks could use Greek government debt as collateral in the ECB's refinancing operations. Due to the start of European Monetary Union (EMU) and the fact that German and other banks can use Greek government bonds to access ECB funding, the holding of Greek debt in other euro zone countries has increased considerably. If the notes were no longer eligible for ECB operations, that would likely lead to an unprecedented sell-off of Greek debt and make it extremely difficult, if not impossible, for the Greek government to place any new issuance and guarantee the servicing of the debt maturing this year.

Greece has to repay investors more than 16 billion euros in April and a total of 53 billion euros this year, and the nation's debt agency said this month it will probably sell bonds by March. The Greek debt agency said on Feb. 2 that the country would probably sell as much as 5 billion euros in March, but the new head said this week that a bond sale isn't currently "in the cards."

Pressure to Soften Austerity Measures

Greece by its own admission has the cash its needs until the middle of March. With European Union officials set to visit Greece next week for talks—together with the ECB and the International Monetary Fund—some traders have suggested that the country is playing "a game of chicken" over the planned 10-year bond sale. The longer Greece delays the issue, the greater will be the threat that the country will actually run out of cash. Some argue that this would help politicians put pressure on the EU and the ECB to soften their stance on austerity measures and possible financial aid.

Greek Finance Minister George Papaconstantinou nevertheless stressed this week that the government will do "everything it needs to meet" its targets. But with the country in the grip of public strikes and unrest in the face of planned budget cuts and tax hikes, officials could argue that their hands are tied if they want to a avoid an escalation of protests.

The EU has said Greece has not asked for financial aid, but Papaconstantinou said his country wants help to borrow at "a viable rate for our economy," which suggest Greece is looking at least for credit guarantees of eurozone bonds, which would allow the country to benefit from better ratings elsewhere in the euro zone.

The reality of a Greek default would of course also put pressure on banks in other euro zone countries that hold Greek notes, which means governments have some incentive to come to the aid of Greece. German Chancellor Angela Merkel's decision will also likely be guided by a sense of responsibility for Europe, even though many officials have argued that German taxpayers should not have to foot the bill.

Becoming a Bottomless Pit?

In the end, we still believe that a default is unlikely and that other governments will come to Greece's rescue one way or the other. They have to make sure, however, that this does not open the floodgates for other euro zone countries and, more importantly, that the funds will be used effectively and that Greece will play with open cards and start to clean up its act.

It is worth keeping in mind that Greece has long been one of the largest net recipients of EU funds, not surprisingly, together with other countries now facing rising deficits, Ireland, Portugal, and Spain. Germany, on the other hand, has been the largest net contributor of the past decade, and German officials will want to make sure that Greece is not turning into a bottomless pit.

Greece's failure to play with open cards with regards to its debt problems is clearly striking a nerve and raising questions over the country's willingness to adhere to the rules of European Monetary Union as well as the euro zone. Greece only now notified Eurostat, the EU's statistical arm, of an off-market swap operation in 2001 and reported that the repayment of the debt began in 2004. It previously told Eurostat that the government was prohibited from using off-balance-sheet derivatives.

At the same time, Greece, pressured into a corner, has started to lash back. Deputy Prime Minister Theodoros Pangalos said in a BBC interview that Germany "took away the gold that was in the Bank of Greece" and never gave it back, so Germany now should not "complain so much about stealing and not being very specific about economic dealings." He also said that current EU leaders are of "very poor quality" and that "the people who are managing the fortunes of Europe [are] not up to the task." Even Prime Minister George Papandreou said Greece had become a "guinea pig" for power games within the EU.

That's hardly solid ground for the EU's visit to Greece next week. Former European Central Bank Chief Economist Otmar Issing has suggested the EU should let the IMF sort out Greece if the EU wants to avoid being blackmailed into bailing out not only Greece, but also other countries in financial difficulties. In the end, however, political reality will in our view force the ECB and politicians into helping Greece with more than advice. Many will regret, however, that the country was accepted into EMU. The admission for future candidates may be much stricter.

Gewaltig is director of European economics for Action Economics .