ECB WATCH: Greece's ECB Eligibility Challenging Beyond 2010

DECEMBER 8, 2009, 9:39 A.M. ET
By Nina Koeppen and Emese Bartha Of DOW JONES NEWSWIRES

FRANKFURT (Dow Jones)--Tuesday's downgrade of Greece's sovereign credit rating has spooked investors because of fears the European Central Bank will stop accepting the nation's government debt as collateral in return for temporary funds.
Fitch Ratings Tuesday cut Greece's long-term foreign currency and local currency ratings to BBB+ from A-. That comes hot on the heels of warnings by Standard & Poor's, which put Greece's A- sovereign rating on negative credit watch Monday, pointing to issues with government finances that could lead to downgrades.
"The outlook is negative," Fitch said, citing dismal public finances, the "weak credibility" of Greece's fiscal institutions and general economic uncertainties.
Greek government bonds remained under heavy selling pressure Tuesday.
At 1330 GMT, the yield spread between 10-year Greek bonds over euro-zone benchmark German bunds had widened about 30 basis points from midday Monday to 230 basis points. That marks the highest level since the second half of April.
"Fitch's move is important because it's the first downgrade of a euro-zone sovereign into the territory where securities were not eligible for ECB collateral until their temporary change of rules in response to the crisis," said Erik Nielsen, Goldman Sachs' chief economist.
Following the collapse of U.S. investment bank Lehman Brothers, the ECB in October 2008 lowered the credit quality threshold for collateral to BBB- from A-, with the exception of asset-backed securities, which require a higher rating. The arrangement is in place until the end of 2010.
"So unless the ECB fiddles with its rules before the end of next year, then from the beginning of 2011, Greek sovereign bonds will no longer be eligible for ECB collateral if Moody's or S&P downgrade them," Nielsen cautioned.
Although Greece is among the countries that most heavily rely on the ECB for temporary funding, most economists believe that the ECB won't refuse to accept Greek debt in its liquidity operations.
Greece's sovereign debt would have to be downgraded several notches to fall below investment-grade and lose its eligibility with the ECB, economists said.
"Greece is very unlikely to lose eligibility at the ECB next year, as it would need to be downgraded below investment-grade over that period," said Jacques Cailloux, an economist at RBS. "But 2011 will be much more challenging, especially if the ECB reverts back to old eligibility criteria," he cautioned.
ECB President Jean-Claude Trichet described Greece's budget situation as "very difficult," but added that the Greek government is expected to take "courageous steps" to trim the deficit.
The Greek government forecast the budget shortfall to reach 12.7% of gross domestic product this year, the highest in the euro zone and well above the 3% limit outlined in European Union rules.