Stabilizing European Sovereign Bond Markets

1. Stabilizing European Sovereign Bond Markets Alain de Crombrugghe 13 Dec. 2011 GRADUATE INSTITUTE OF INTERNATIONAL AND DEVELOPMENT STUDIES

2. 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.

3. 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 ».

4. 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.

5. 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.

6. 2. Objectives 1. NOW • 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 • 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, … The firefighters (ECB + safe govt) want to be safe enough 2. LATER

7. 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.

8. 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).

9. 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).

10. 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

11. 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.

12. 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)

13. 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?

14. 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.

15. 6. ConclusionRealism, 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).

16. 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

17. 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)

18. 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/PDG-papers/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-the-blue-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”