Download How to reduce procyclicality in the Eurozone?

How to Moderate the Procyclical Nature of the EMU?
Juraj Kotian, Head of Macro/Fixed Income Research CEE
Erste Group Bank
Procyclical policy cocktail will always lead us to
boom and bust periods
•
Pro-cyclical fiscal policy
•
Pro-cyclical and adverse common monetary policy
•
Nexus between governments and banks - bailouts &
moral hazard vs. debt resolution
Governments
Nominal criteria were procyclical and inefficient
Slovakia
Change in structural balance
Change in structural balance
Greece
real GDP growth
real GDP growth
Source: AMECO, Erste Group Research, period 2004-2013 (years 2009-2010 excluded)
Some advanced economies managed to do the
anticyclical fiscal policy
Correlation between real GDP growth
and change in structural balance (2004-2013)*
Source: AMECO, Erste Group Research
*years 2009-2010 were excluded
The lesson learnt from past mistakes:
•
Macro-prudential policy: tight fiscal policy during the
boom years and more expansionary during the downturn
•
Nominal criteria have been already replaced by structural
criteria (six-pack)
•
Nominal criteria have formally remained in place in SGP,
but have become less important
•
Surveillance process and the sanction mechanism have
been strengthened
Will better governance be enough for limiting the
procyclicality?
•
No. We desperately need reliable debt resolution
scheme for sovereign debt
•
Correct pricing of default risk during ‘good times' should
prevent countries from running a high debt or primary
deficits
•
Reduced moral hazard - creditors should bear losses
Fiscal union with a common budget
•
For what do we need a transfer union? Cohesion or
countercyclical fiscal action?
•
Pooling of cyclically sensitive tax revenues vs. robust
tax revenues (excise taxes, VAT)
•
Covering of cyclically sensitive expenditures (automatic
stabilizers or public investments?)
•
Paying the interest payments on commonly issued
bonds (i.e. Eurobonds)
Austerity vs. Stupidity
Lorenzo Bini Smaghi
(a former member of the ECB’s Executive Board)
‘Austerity has certainly caused low growth but may itself
be the result of the poor and unbalanced growth
performance before the crisis, which was due to the lack
of reform. The postponement of reforms to improve
growth potential has left countries with only one solution,
austerity. Austerity is thus the result of policy makers’
past inability to take timely decisions, in other words it’s
the result of their short sightedness – and stupidity.’
Monetary policy
One size does not fit all
•
Members would need a different level of real interest
rates and real exchange rates
•
Larger cyclical swings among member states makes the
common monetary policy even more adverse
•
Nexus between banks and governments bring
procyclical problem to even higher level and makes
monetary transmission mechanism inefficient
Tailor rule interest rate should range between 15% to 4%
Source: Zsolt Darvas, Silvia Merler (Bruegel 2013)
Nexus between sovereign and banks makes the
transmission mechanism of common monetary policy even
more challenging
Correlation between sovereign and banking CDSs
Source: VOX (Wolff, Angeloni 2012), weekly averages over the period January 2011- February 2012
Resulting in tight monetary conditions in countries where
the optimal monetary policy would need to be
accommodative
SMEs Interest Rate spreads to Germany
(loans up to EUR 1m with maturity of up to 1 year)
Source: EC Economic Forecasts (Autumn 2013)
Nexus between banks
and sovereigns
Moral hazard in pricing of government debt
•
Markets had been betting on implicit bailout of sovereigns
and absence of redomination risk
•
Zero risk weight on sovereign – home bias
•
IMF breached its own rules and provided financial
assistance to insolvent country (Greece,...?)
•
Key arguments: No debt resolution scheme for sovereign
debt- disorderly restructuring would cause contagion and
meltdown of financial sector in the EA
LTRO helped to the financial fragmentation, moral
hazard and regulatory arbitrage
Viral Acharya, Sascha Steffen (2013): The banking
crisis as a giant carry trade
‘Under-capitalised banks had incentives to shift further into risky
sovereign debt as the failure of this trade is precisely when they
are also insolvent and they benefit if sovereign bond prices
improve, as described in Diamond and Rajan (2011) (i.e. ‘risk
shifting’). Basel II regulation that requires banks to meet a
capital ratio based on regulatory equity and risk-weighted
assets provides banks incentives to shift into assets with lowest
risk weights, i.e. sovereign debt. As sovereign debt had zero
capital requirements for all banks, banks had incentives to shift
into these risky assets (‘regulatory capital arbitrage’).’
Investments into domestic government bonds
have increased the nexus
Share of domestic government bonds as % of total assets
Source: Silvia Merler (Bruegel, 2013)
How to fix it?
•
Debt resolution scheme for sovereign
•
Introduction of non-zero risk weights for sovereign
•
Reduction of home-bias for investments into sovereign
portfolio through concentration risk
Banking Union
•
Common resolution fund, minimum amount of bail-in
eligible liabilities
•
100% deposit guarantee should be reconsidered in
order to tackle the adverse selection
•
Non-zero risk weights for domestic sovereign bonds
•
Eurobonds with senior status over the local (national)
debt would be the most efficient tool for breaking the
nexus between banks and sovereigns
Eurobonds as an option for debt exchange
programme
•
Eurobonds with senior status should replace part of the national debt (but
not 1:1)
•
In auctions of Eurobonds, national bonds could be used for settlement the highest bids would be accepted until the country quota (i.e. up to 60%
of GDP) is consumed
•
It would correspond to voluntary private sector involvement
•
Remaining part of debt (i.e. above 60 percent of GDP) would remain
‘national’ (subordinate) and could be subject of occasional default
•
'Disorderly' default would not be an option, occasionally orderly sovereign
debt restructuring would be possible
Summary
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Following structural rather than nominal criteria
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Enforce the fiscal discipline via better pricing of risk of default
•
Make the sovereign default possible
•
Introduction of non-zero risk weight for domestic sovereign bonds
•
Bank resolution scheme
•
Introduction of commonly issued bonds (i.e. Eurobonds) which would help
to break the nexus between banks and sovereigns