ECB opposing almost any form of Greek debt restructuring

– Compromise might be found short of Schaeuble's proposal

Just over a year ago, European Central Bank President Jean-Claude Trichet was asked whether the bank would consider buying euro zone governments' bonds in the open market to help tackle the bloc's debt crisis.

"I would say we did not discuss this option," he told a news conference after an ECB Governing Council meeting in Lisbon. Other ECB officials had publicly denounced the idea as violating the principles of strict monetary management.

Four days later, the ECB said it would start buying bonds, making a U-turn as part of an emergency package put together with euro zone leaders. The controversial step ultimately led to German central bank chief Axel Weber quitting his post.

Fast-forward to the present day, and the ECB is again under pressure to compromise on its principles and steadfastly refusing to do so. It opposes any scenario that would force private sector bond investors to share the burden of bailing out Greece by restructuring its debt.

The ECB has even threatened to use its so-called "nuclear option": refusing to accept restructured Greek bonds as collateral in its lending operations, a scenario that would cut off funding to much of Greece's financial sector.

But past form and the weight of pressure which the ECB faces from euro zone governments suggest it may yet make another U-turn, or at least soften its position to permit some form of debt restructuring to go ahead.

SCHAEUBLE

Though he denies any quarrel, Trichet is clearly at odds with German Finance Minister Wolfgang Schaeuble, who has demanded a "quantified and substantial" contribution from bond holders as part of any new aid package for Greece.

Schaeuble, facing domestic pressure to involve the private sector in the package, has suggested a bond swap that would effectively extend the maturities of Greek debt by seven years.

The major credit rating agencies have said they would probably classify any debt rollover as a default because even if it were presented as voluntary, there would be an element of coercion: investors would be taking part because they feared the consequences of not doing so.

Trichet took a hard line on the issue of default on Thursday, telling a news conference after the ECB's latest policy meeting: "We would say it is an enormous mistake to embark in decisions that would trigger a credit event."

He added, "We exclude all concepts which would not be purely voluntary. We call for avoiding any credit event and selective default. And of course default."

OPPOSITION

The ECB argues that any form of default could spook financial markets and trigger another Lehman-type crisis in the euro zone, pushing up bond yields for countries such as Spain.

Also, the ECB has bought about 45 billion euros of Greek government bonds; if a default forced it to take losses on that debt, it might have to ask governments for fresh capital and a dangerous precedent would have beem set for central bank involvement in debt crises.

David Marsh, author of 'The Euro: The Politics of the New Global Currency', believes Trichet — whose term as ECB president will expire at the end of October — is focused on the fate of the broader euro zone.

"I'm convinced the ECB and the central banks behind it are not just talking their own book because they are worried about their balance sheet. There is a systemic issue here that a voluntary restructuring is very difficult to achieve without driving not just Greece but other countries into a wider default," he said.

David Mackie, analyst at JPMorgan, said he believed Trichet wanted to avoid the use of debt restructurings to resolve euro zone crises because he hoped the bloc would instead assert control over the fiscal policies of crisis-hit states.

In a speech last week, Trichet delivered his vision of a euro zone run along those lines, suggesting the bloc might eventually establish a central finance ministry.

"If the ECB is successful in its attempt to prevent any kind of debt restructuring in the near term, the region will indeed move down the path towards the destination that Trichet wants it to go to," Mackie said.

COMPROMISE

But many euro zone governments, led by Germany, have different priorities. They face popular discontent with the mounting cost of the euro zone crisis, and Berlin feels it must involve the private sector in sharing the burden — primarily the banks which many people blame for starting the global credit crisis that fuelled the euro zone's debt problems.

Clemens Fuest, a professor at Oxford University and a member of the academic advisory board of the German Federal Ministry of Finance, said the ECB must be ready to compromise on its insistence that any sovereign debt restructuring be voluntary and non-binding on private sector creditors.

"The compromise cannot be that there is a shifting of all the burden of the debt to the taxpayer," Fuest told Reuters Insider television in an interview.

"The language is stark at the moment, but if we look back the ECB has bought government bonds during this crisis to fight the crisis, so it is already a party in the crisis and it has deviated from the very strict and clear rules for normal situations," Fuest said.

"I think these rules are fine for normal situations but in the crisis we have to find something, to find solutions so I think in the end the ECB will be ready to compromise."

Such a compromise, some European officials suggest, might take the form of a less dramatic debt rollover than the bond swap envisaged by Schaeuble — perhaps a commitment by private investors to buy new Greek bonds when existing ones mature.

The rating agencies would probably still declare a default, but it might be a limited or "selective" default that was brief in duration, had a modest impact on markets and did not force the ECB to take losses on its holdings.

Rejecting this option and carrying out its threat to cut Greek banks off from funding, throwing the euro zone's banking system into chaos, might be politically impossible for the ECB.