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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)
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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 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
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. 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).
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/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”