Download Stabilizing European Sovereign Bond Markets

Stabilizing European
Sovereign Bond Markets
Alain de Crombrugghe
13 Dec. 2011
GRADUATE INSTITUTE OF INTERNATIONAL AND DEVELOPMENT STUDIES
Outline
• 1. Instability, spreads and costs
• 2. Objective (s)
• 3. Institutional framework
• 4. Stability funds (EFSF, ESM)
• 5. Larger Eurobonds proposals
• 6. Realism, responsibility and solidarity
References.
1. Instability, spreads and costs
• Multiple Equilibria
–
–
–
–
At 3% interest on its bonds, Italy is solvent
At 7% on a few refinancings, Italy is broke.
Once markets believe a country is broke, it will be.
Contagion (from Greece to Italy).
• Liquidity and flight to quality
– Fear increases spreads, freezes markets,
– Safe and « deep » assets demanded as collateral.
• Moral Hazard
– Hard to distinguish between « bad luck » and « bad
will ».
– Risk premium should deter bad « will ».
– Low interest rates should finance worldwide bad
« luck ».
1. Instability (cont’d)
• Inflation risk
–
–
–
–
None in a recession,
No signs in LT interest rates, nor even wages,
No net monetary finance if no moral hazard,
Possibly ‘supply shock’ (relative prices).
• Costs
– Debt growth, cost of servicing, social or tax wedge,
– Bank instability and refinancing, credit crunch,
– Recession, second round (Bank-gov-bank) and third
round (employment-consumption) effects.
– Safest countries hit by recession, weakest countries
by contagion.
Instability (cont’d)
• Newer issues : Monetary union
– In crisis : Monetary union worsens weak countries
costs and competitiveness and temporarily protects
safer countries.
– In good times : Monetary union shelters weak
countries and delays reform.
• Newer issues : Weak sovereigns
– Some governments now borrow at higher rates than
their private sectors, losing one traditional rationale
for keynesian fiscal policy.
– Excessive reliance on markets, not enough on
savings.
– Strong sovereigns can still act.
2. Objectives
• Fight the fire (De Grauwe 2011)
– Keep solvent countries solvent at low r.
• Set up a fire brigade
– Have means and rules to use them.
• Reduce fire damage and risk
1. NOW
The
firefighters
(ECB +
safe govt)
want to be
safe
enough
– Fight moral hazard (get incentives right)
– Plan budgets over the cycle and beyond (aging!)
• Build a new city
– European fiscal federalism
• Get more means, not more fuel
– Liquid eurobonds on safe grounds (issuer,
quantity, backing),
– Benefit from eurobonds liquidity gain, use as
international collateral, as safe heaven, …
2. LATER
3. EU Institutional Framework
• Treaty : No Bail out
• EFSF :
– European Council March 2011 : enlarge art 136,
– Funds voted in all 17 Eurozone parliaments (440 Bn €)
– About 250 left after Greece, Ireland, Portugal
• ECB independence
–
–
–
–
Inflation objective
Banking stability responsibility
No direct government finance
Instruments : interest rate, collateral, auctions + open market
• Commission : Initiative and Execution
• Stability and Growth Pact
– March 2011 : more stability and (non-credible) sanctions, not
more growth.
4. Stability Funds :
Objectives and incentives
• Objective 1 : Stabilize rates (and bond prices)
• Primary Market (new issues) : EFSF
–
–
–
–
Direct finance of new borrowing (Delbecque 2011)
Guarantee on refinancing of existing debt
Pre-set maximum rate (ceiling to market or local rate)
Pre-set amount : Conditional on approved budget.
• Secundary market : ECB (or eurobonds, later)
– Guided by primary market ceiling rate and conditions.
– Inframarginal interventions with « target zone effect ».
• Feasible in current institutional framework
• Includes incentives (funds) and sanctions (rates).
Stability funds :
Conditions
• Stability finance generalizations :
– Can work also for non-Euro countries (rates and
amounts set in other currencies if needed),
– Can be monitored by IMF instead of (or in
cooperation with) EU Commission,
– Currently IMF-run for Poland (preventive effect works
on Polish budget and on market rates!)
• Conditions :
–
–
–
–
No seniority (see Gros 2011 : effect on other bonds)
Pure liquidity problem (or full solidarity)
Agreed budget (fiscal pact implementation).
Agreed rates and issues
(participation constraint and incentive compatibility).
Stability funds :
Funding
• Contribution of Euro members : 440 Md
– Shares according to GDP : Germany ± 200 Md.
– Maximum, voted in parliaments.
• Borrowing
– Higher rate than average of members ! 7/11 : 3,59% at 10
y. Lower liquidity? Fear of slow execution of guarantees?
http://www.efsf.europa.eu/
– Why not direct issues by high rating members (or swaps) ?
• Leverage
– Tranche guarantee instead of full lending ?
– Cooperation ? (European Council October 2011)
– Interest margin earned to fund ?
• ECB (no agreement yet)
– Secundary market (open market operations)
– More effective than through bank liquidity
Stability funds :
Risks
• Free-riding, moral hazard, insolvency
• Lobbying by banks
• Debt buy-back effect
– Bulow and Rogoff 1991 : gain for remaining creditors,
– Reduces debt overhang, uncertainty (Brady bonds),
– Can be ‘tailored’ to creditors.
• Participation of the private sector ?
– Agreed March (CAC’s 2013 ESM), July 2011 (Greece
20%), October (Greece 50% voluntary)
– Dropped December 2011 (Merkel-Sarkozy 5 dec,
deal: no eurobonds, no CAC’s).
– CAC’s are a negative « signal », raise marginal cost
of borrowing.
– Impose recapitalization of banks, act fast.
5. Eurobond proposals :
Objectives and incentives
• Objective 2 :
– Liquidity effect, reference effect, collateral.
• Common pool of bonds
– A « large » « safe » part (60% of GDP) of Euro members
debt is sold to a European fund («blue bonds»),
– This fund issues safe « eurobonds »,
– Seniority of the fund, guarantee. (EU Commission Green book 2011)
• Incentives (objective 1 in its prevention part)
– Quantity, incentive compatibility : Liquidity and safety
gain for these bonds (« blue bonds »), but higher
marginal borrowing rates at country level (« red
bonds »). (Delplaand and von Weizsacker, Bruegel 2011)
– Price, participation constraint : Each country pays
interest on its debt to the fund with a spread determined
by its marginal borrowing rates. (de Grauwe and Moesen 2009)
5. Eurobond proposals :
Conditions and effects
• Conditions
– First, safest tranche of national debt (GDP based, say
60% of GDP, including roll over of this tranche)
• Effects
– Seniority of first tranche (blue bonds) raises marginal
interest cost of national tranches (red bonds),
– No stabilizing effects in case of a crisis : stability fund
still needed (yellow bonds ?) (Objective 1 stability part).
• Problems
– Countries with Debt/GDP ratio < 60% ?
– Distinction between « blue eurobonds » and « stability
fund bonds »
• on the european market or merging (and extending to
corresponding average debt/GDP ratio)?
• In determination of individual country interest rates?
Eurobond proposals :
Funding and risks
• Funding
– Large market
– Possibility of open market interventions of ECB as the
bonds are « inframarginal » (no direct government
funding)
• Risks
– Limited if participation constraint is solved and if
stability intervention is well designed.
6. Conclusion
Realism, responsibility and solidarity
• Stability fund (and bonds) first,
– Incentive effect :
• On country : conditionality, cfr rating
• On markets : interest ceiling, « target zone »
– Needed despite risks, doable with current institutions
(and started), could be strengthened
• Eurobonds
– Incentive effect via gain on inframarginal borrowing
and cost on marginal borrowing
– Probably not self-sustaining : fiscal pact required
(responsibility).
REFERENCES
VOX EU and Project Syndicate
• De Grauwe, Paul (2011), “The European Central Bank as a lender of last
resort”, VoxEU.org, 18 August 2011. (Buy gov. bonds)
• De Grauwe, Paul (2011) «Why the ECB refuses to be a lender of last
resort » VoxEU.org, 28 Nov 2011. (Timing of bank vs government finance)
• Delbecque, Bernard (2011) “Capping interest rates to stop contagion in the
Eurozone” VoxEU.org, 17 October 2011 (focus on new issues).
• Gros, Daniel (2010), “The seniority conundrum: Bail out countries but bail in
private, short-term creditors?”, VoxEU.org, 5 December.
• Hau, Harald (2011) “Europe's €200 billion reverse wealth tax explained” Vox
EU 27 July 2011 (cfr Bulow-Rogoff 1991 on debt buy-backs)
• Rajan, R. (2011) “A stand by program for the Eurozone” Project Syndicate
17 oct. 2011.
• Wyplosz (2011) “A failsafe way to end the eurozone crisis” VoxEU 26 sept
2011.
• Wyplosz (2011) “Resolving the current European mess” VoxEU 25 oct 2011
in Beck, Thorsten, Ed. (2011) The future of Banking, CEPR and VoxEU, 25
oct 2011, http://www.voxeu.org/index.php?q=node/7147
REFERENCES
EU Council or Commission documents
• European Council : Conclusions 24-25 March 2011 (six-pack, European
semester, competitiveness «euro-plus pact», EFSF and Treaty art 136.3),
EUCO 10/11
• European Council : Declaration 21 July 2011 (1st Greek debt restructuring,
EFSF outreach),
• European Council : Euro Summit Statement and Euro Summit Declaration :
26 Oct. 2011 (Eurozone only, 2d Greek debt restructuring, policy
coordination)
• European Commission : « Green Paper on the feasability of introducing
stability bonds » 23 Nov 2011:
http://ec.europa.eu/economy_finance/consultation/stability_bonds/pdf/green
-pepr-stability-bonds_en.pdf
• European Council : Conclusions 8-9 Dec 2011 EUCO 139/11.
• European Council : « Statement by the Euro area Heads of State or
Government » 9 Dec. 2011 (Fiscal Pact, ESM earlier and stronger,
exceptional CAC’s)
REFERENCES
Articles:
• Arslanalp, Serkan; Henry, Peter Blair (2005) “Is Debt relief efficient?” Journal of
Finance, April 2005, v. 60, iss. 2, pp. 1017-51(find effect of Brady bonds on local
stock market, re-entry of FDI, and lender stock value.) (could be replicated)
• Bekaert, Geert & Gray Stephen (1998) “Target zones and exchange rates: an
empirical investigation” Journal of International Economics 45, 1-35.
• Bulow, Jeremy, and Kenneth Rogoff. 1991. "Sovereign Debt Repurchases: No Cure
for Overhang." Quarterly Journal of Economics 106, no. 4: 1219-1235. (Remaining
creditors gain more than debtors)
• De Grauwe, Paul (2011) “The Fragile Governance of the Eurozone” KULeuven and
CEPS Working Paper. (Quoted by Paul Krugman)
http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDGpapers/Discussion_papers/Governance-fragile-eurozone_s.pdf
• De Grauwe, P. and Moesen, W. (2009) “Gains for all : A proposal for a common Euro
Bond” Intereconomics, May-June, 132-135.
• Delplaand, Jacques and von Weizsacker, Jakob (2011) « Eurobonds: The blue bond
conept and its implications » Bruegel Policy Contribution 2011/02, March, 6 pp.
http://www.bruegel.org/publications/publication-detail/publication/509-eurobonds-theblue-bond-concept-and-its-implications/
• Krugman, Paul R. 1991. "Target Zones and Exchange Rate Dynamics." Quarterly
Journal Of Economics 106, no. 3: 669-682.
• Masson, P. (1999), “Contagion: macroeconomic models with multiple equilibria”,
Journal of International Money and Finance 18, 587-602.
• Obstfeld M. & Rogoff K. (1996) “Foundations of International Macroeconomics”
MIT Press, Chapter 6 “Imperfections in International Capital Markets”