Posted by: Dirk | June 10, 2021

Why are Greek bonds a success story today while they were not in the Euro Crisis that started in 2010?

I wrote this tweet because I thought that it would be really interesting for students to ask that question. They would find out what it is that determines the price of a government bond. Little did I know that many people would be interested in my view of the issue. So, by popular request, here is my take. (It is based on my book on money creation in the Eurozone [€] and a paper in the Eurasian Economic Review [no paywall] with Michael Paetz.)

Let us start with the figure that dominated the Bloomberg article I quoted [if you already understand the relationship between bond price, interest rate and yield you can skip the section and move to where I repeat the question from the title of this post]:

What we have here is the spread on Greek 10-year bonds over bunds (German government bonds, Bundeswertpapiere in German, short: bunds). A spread is a difference in yields, which are measured in basis points. There are 100 basis points in 1%. Or 1 basis points equals 0.01%. Such a difference might seem small, but bond markets are huge and we are talking about billions of euros sometimes. Even 0.01% (=1 basis point) of that is not negligible.

What is a yield, then? To understand that, we need to know what government bonds are. They are I.O.U.s (I owe yous), instruments of debt, promises of (future) payment. Government bonds are usually issued by the Treasury, which belongs to a government. They contain information about how much will be (re)paid, when and with what interest rate. 10-year bonds have a maturity of ten years, and this is what we are dealing here. (That does not mean that it is different for bonds of other maturities.)

So, the bond contains the information that they will be repaid at some point in the future, say 2031. The bond also contains the principal, which is the amount that the holder will receive at maturity (in 2031). Last but not least there is the interest rate that is paid no the principal. It is normally fixed, but variable rates are possible. In the Eurozone, Greek government bonds usually have fixed rates. All that information is fixed when the bonds are issued. After that, only their market price can change. This is where it gets interesting.

Let’s say we look at a Greek government bond which pays out €100 million in 2031. The interest rate it carries is 0.75%. This means that if the holder of the government bond would wait until 2031, she would receive €107.5 million (principal of €100 million plus ten years of interest of 0.75% of 100 million, which equals 7.5 million). The yield of this bond (which is *not* what you see in the figure above – that’s the spread) is determined by the market price of the government bond. So, what would be the market price of this bond?

The answer is €99.185 million. Why? Because that’s what it is right now (link to CNBC). The yield is 0.835%. It is higher than the interest rate of 0.75% because you can buy the bond at less than €100 million. Now the difference between that yield and that of a similar bond from Germany – the bund – is what you can see in the figure above. It reached almost zero in 2019 (before the pandemic), then went up somewhat and came down again. It is now below 100 basis points (or 1%) as the figure says. However, that was not the case in the years following 2010.

Why are Greek bonds a success story today while they were not in the Euro Crisis that started in 2010?

In 2010, investors thought that the Greek government might run into trouble. In the aftermath in Global Financial Crisis (GFC), tax revenues in Greece collapsed as economies everywhere stalled. In the Eurozone, of which Greece is a member state, the countries hit hardest were those with the real estate bubbles: Ireland and Spain. These were the main causes for the European side of the GFC. The collapse in real estate investment lead to high unemployment and this spilled over into the European economy as Spaniards and the Irish more or less stopped buying machines and cars from other European countries, like Germany.

Investors thought that the Greek government might run out of money and not be able to pay back the principal when their government bonds mature. Or, the Greek government might force investors to swap their old bonds into new bonds that pay out only half of what was agreed. When investors think that way, they will sell Greek government bonds. If they don’t do the same with German government bonds, this will result in a rising spread. This is what you see above. Investors thought that the Greek government might run out of money and that finally happened. Enter the Euro crisis, or European Debt Crisis, as Wikipedia has it.

By the way: the way the Eurozone works a government usually spends money via its national central bank. When it executes payments of the government, it marks up the receiving banks account at the central bank (reserves) which then marks up its client’s account (bank deposits). However, in the Eurozone it is not allowed that national central banks “finance“ (read: execute payments for) the national government. So, central banks do create reserves when its government spends, but the account has to revert to zero by the end of the day. This means that the government starts the day with zero euros in its central bank account and then it is driven into negative territory by government spending. I have described the details for Germany in a working paper, probably the Greece fiscal-monetary nexus is not that different.

How does the government get its account back to zero? It can move tax revenues there and also bond revenues. If tax revenues are not enough, then the question whether a government can spend only depends on its ability to sell bonds. If nobody wants to buy bonds, the government’s account will not revert to zero and this will give the central bank a red light. It is not allowed to spend for the government. That does not mean it cannot, of course. It clearly can still mark up accounts of the banks inside its jurisdiction. It won’t do that because it is against the Eurozone rules.

So, what is different today? Why do investors believe that the Greek government can sell all these government bonds? There is only one reason. The ECB changed its mind about its role. While it did not buy Greek government bonds in 2010 and after, now it does. In March 2020 it announced the Pandemic Emergency Purchase Programme (PEPP). Here is what the ECB says (my highlighting):

The PEPP is a temporary asset purchase programme of private and public sector securities. The Governing Council decided to increase the initial €750 billion envelope for the PEPP by €600 billion on 4 June 2020 and by €500 billion on 10 December, for a new total of €1,850 billion. All asset categories eligible under the existing asset purchase programme (APP) are also eligible under the PEPP, as well as a waiver of the eligibility requirements has been granted for securities issued by the Greek Government.

So, the ECB has decided to buy up Greek government bonds. This changes the calculation for investors. If they can expect to sell their Greek government bonds to the ECB at any time at the market price, it does not matter anymore whether the Greek government runs out of money or not. Before that would create a problem, the investors would already have sold her bonds to the ECB! This is why investors are happy to hold Greek bonds now and not ten years ago. It is the support of the ECB that does it. What also helps is that the deficit limits of the Stability and Growth Pact are deactivated for now.

So, Greek government bonds are a success story today because the ECB now supports the liquidity and solvency of the Greek government (and the other national governments) which it did not in the 2010 Euro Crisis. Since the PEPP is not permanent, this is where we are today. What tomorrow brings will be decided by the European policy makers at both supranational and national level and by the Europeans, who get to vote on some of these issues and determine who is in charge.

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