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1 Making Europe Safer Prof. Stijn Van Nieuwerburgh Member of New York University Stern School of Business National Bank of Belgium, December 22, 2011

2 Agenda Diagnosis of design issues in the Eurozone Destabilizing capital flows Diabolical loop between sovereign and banking crises Proposal: European Safe Bonds and European Junior Bonds How they help long-run How they help short run Financial sector reform

3 Eurozone: 10yr sovereign debt yield Par Yield Par Yield Spain 5 Germany 0 Jan 94 Jan 97 Jan 00 Jan 03 Jan 06 Jan 09 Source: Eurostat

4 Eurozone: 10yr sovereign debt yield Par Yield 25 Par Yield Italy Greece Spain 5 France Germany 0 Jan 94 Jan 97 Jan 00 Jan 03 Jan 06 Jan 09 Source: Eurostat

5 Eurozone: Persistent Inflation Divergence Par Yield Mo. Moving Average HCPI for Eurozone (1999=100) Par Yield 160 Spain 140 Germany Jan 96 Jan 00 Jan 04 Jan 08 Source: IMF

6 Eurozone: Persistent Inflation Divergence Par Yield Mo. Moving Average HCPI for Eurozone (1999=100) Par Yield 160 Greece Spain 140 Italy France Germany Jan 96 Jan 00 Jan 04 Jan 08 Source: IMF

7 Real interest rate gap Average rates Germany Spain Greece Nominal interest rate 3.8% 3.9% 4.4% Inflation rate 1.8% 3.3% 3.5% Real interest rate 2.0% 0.6% 0.9% Rate for German savers > Rate for Spanish/Greek borrowers (Government) Consequence: Source: Bloomberg 5 year government note indices larger savings in Germany + capital outflows boost to Spanish economy & inflation 7

8 Eurozone Accumulated Net Capital Inflows Billion Q Q Q Q Q1 2006Q Source: Eurostat Billion 800 Spain Germany

9 Eurozone Accumulated Net Capital Inflows Billion Q Q1 1997Q1 2000Q1 2003Q1 2006Q Source: Eurostat Billion 800 Spain 600 Greece 400 Italy 200 France Germany

10 Eurozone: Accumulated GDP Growth Percent Percent Eurozone Spain Germany Jan 95Jan 97Jan 99Jan 01Jan 03Jan 05Jan 07Jan 09Jan 11 Source: OECD

11 Eurozone: Accumulated GDP Growth Percent 100 Percent Ireland Spain 60 Greece 40 Belgium 40 Portugal France 20 Eurozone Germany 20 Italy Jan 95Jan 97Jan 99Jan 01Jan 03Jan 05Jan 07Jan 09Jan 11 Source: OECD 11

12 Crisis diagnosis 1: Flight to safety coordinate on which safe asset to flock to in times of crisis - appreciates in times of crisis Today: asymmetric shifts across borders Value of German debt increases Value of Italian/Spanish/Greek sovereign debt declines 12

13 Crisis diagnosis 2: Diabolic Loop Sovereign debt is treated as safe asset Basel: Zero risk-weight (for own sovereign) ECB: Low haircut e.g. 10 year Greek bond has 10% haircut Concentration of sovereign risk in banks In today s environment, European banks have no safe assets (with exception of German Bund)

14 Crisis diagnosis 2: Diabolic Loop Contagion due to diabolic loop twin crisis Trigger Bank insolvency (Ireland, Spain) Public debt/slow growth (Greece, Portugal, Italy) Banks need safe asset for transactions (collateral, Basel II and III prudential regulation) 14

15 Polling Question No: 1 What was the biggest cause of the divergence in performance between periphery and core in last decade? A) Lack of fiscal discipline of governments in periphery B) Cheap money encouraged too much private sector borrowing in periphery C) Productivity differences D) Financial system fragility in periphery

16 European Safe Bonds (ESBies) proposal 1. Creates safe asset Banks have safe alternative to own-country sovereign bond With flight to quality correlation structure 2. Breaks diabolic loop between banking and sovereign credit risks ECB grants ESBies preferential treatment + haircuts for sovereign debt Appropriate Basel risk weights + higher weights for sovereign debt 16

17 Our Proposal A EDA L sovereign bond portfolio of 17 EZ countries Weight of each country in portfolio equal to its relative size Total scheme capped at 60% of GDP ( 5.5tn) Pass-through: Issues 2 securities sold to private market No control rights for EJB holders European Safe Bonds (ESBies) European Junior Bonds (EJBs) X% 17

18 Flight to safety: in times of crisis A L sovereign bonds ESBies EJBs Today: asymmetric shifts across borders With ESBies: Negative co-movement across European bonds Value of ESBies expands due to flight to quality Value of EJBs shrinks due to increased risk Asset side is more stable 18

19 Incentives for reform ESBies do not distort incentives for sovereigns to undertake structural reform Sovereign bonds will still need to be placed in secondary markets for countries with debt-gdp above 60% (nearly all countries) Interest rate signal as corrective (market) force should remain intact In fact, by moving to a new stable equilibrium, governments may be able to credibly commit not to bail out, making interest rates more informative 19

20 Summary: advantages Brings stability to banking sector by breaking diabolic loop Eliminates capital flow imbalances due to search for safe haven ESBies liquidity premium ( 40bn per year in normal times and more in crises) shared across all euro-members No fiscal transfers/joint liability, unlike eurobonds! No need for (unpopular) political unification No need for Treaty changes to implement 20

21 Design: How to % of EJBs? Design principle: maximize safety, not profits! We propose X=30% based on conservative assumptions on Sovereign default probabilities Their correlation across countries Different macro scenarios Overlay contingencies, if Italy goes, Spain goes with very high likelihood, etc. Loss given default given the credit rating ESBies would sustain losses in only 0.8% of 5-yr simulations (once every 600 years)

22 Design: credit enhancement for ESBies Concern: Standardization across various issues A EDA L sovereign bonds ESBies EJBs credit enhancement A Assets according to ECB key EFSF L Guarantees granted Credit enhancement cannot be provided privately EFSF could provide this guarantee Would be a useful way to leverage its monies 22

23 Design: Governance of EDA Mechanical: portfolio weights according to strict, stable, credible, and transparent rules In crisis, temptation to lift 60% limit Strict governance is important Open yourself up to private law suits from Former/current ESBies holders Former/current EJB holders Needed to provide truly safe security 23

24 How ESBies can help short run Give credible path out of current panic Increases sovereign debt prices by preventing multiple equilibrium, market freeze, fire sale prices Initially, focus on newly issued sovereign debt Primary market purchases in proportion to GDP Ex. Could buy 940bn in Italian debt, next 3 years At least 3 years for all countries to make necessary structural adjustment and ride out business cycle Program countries (Greece, Ireland, Portugal) would not participate in ESBies until later 24

25 Who buys the junior bond? High risk, high return: 10yr EJBs currently 10% p.a. Hedge funds and sovereign wealth funds Can t they take on levered sovereign risk already? Yes, a hedge fund can buy the portfolio of sovereigns on margins and lever it up, but margin calls may force deleveraging at the worst possible time EJBs provide fixed embedded leverage Retailize junior bond Design ETFs for retail investors with EJB as underlying Recall: State bonds in the US are mostly held by households, as are many European sovereign bonds 25

26 EFSF as market maker for EJB A German bund Low/negative correlation Italian Bonds EDA ESBies EJB L EFSF Collateralized Credit line ECB Automatic recapitalization larger capital share Increased influence Hedge funds, SWF Households (via ETFs) Member States 26

27 Q&A: Didn t CDOs bring us in this mess? Yes, fight fire with fire. ESBies Are simple and very transparent Asset side contains liquid sovereign bonds with a traded price Objective is not to largest ESBies tranche, but maximum safety We use extremely high correlation assumption 27

28 Q&A: Don t you force banks to realize losses? Not relevant for initial phase (EDA only does primary market purchases) Later, swap of sovereign bonds for ESBies could trigger banking book losses and may necessitate bank recapitalization, but The introduction of ESBies will stabilize the market (if communicated well as part of a long-run package) Market prices will increase and allow a restructuring Redistribution of liquidity premium (which is very high right now) towards peripheral countries 28

29 Q&A: Maturity transformation Should the European Debt Agency (EDA) be active in maturity transformation? No. Otherwise who should be the LOLR? How to ensure this? EDA can only buy according to weights per maturity E.g. one year paper up to 5% of GDP, two year paper up to Demand pressure will make it attractive for each sovereign to adjust their maturity structure to EDA s demand What maturity of ESBIES should the EDA issue? whole yield curve 29

30 Q&A: Don t ESBies also create externalities? Isn t it the case that if a country s probability of default increases, it will increase the yield of EJBs, increasing funding costs for all? And that the country does not internalize this effect on others? Not with perfect market liquidity. Without ESBies, misbehaviour of country X hurts its existing creditors, but the country would bear the full cost on all new debt. With ESBies, it s the same. Price of new debt drops. Indeed, the country would have to sell some of its debt in the market and some to the EDA, but at market price. Note, ESBies/junior bond is just repacking With imperfect market liquidity 30 Some externalities might arise, but small in scale.

31 Q&A: Will EDA break even? Concern: situation where the EDA Buys individual sovereign bonds at high ask price Sells ESBies and EJBs at low bid price 3 options of purchase 1. Only secondary market 2. Primary market as regular bidder 3. Primary market with fixed quantity (like submitting market order) Recommendation: Option 2, since temporary price pressure from option 1 may be non-trivial 31

32 Q&A: Remaining sovereign debt illiquid? Illiquid bonds would have low prices, little price discovery But ESBies and EJBs will be more liquid and if the EDA makes profit off this extra liquidity, it can be redistributed back to the national Treasuries If sovereign debt < 60% of GDP Country gets average (best of) AAA rated country Provides incentive to lower debt/gdp ratio 32

33 Conclusion ESBies Smooth flight-to-safety fluctuations Break diabolic loop (in the long-run) Share liquidity premium (at expense of Bund, US Treasury) One element to overcome the crisis! In parallel, need to promote medium-term growth prospects through structural reform, financial stability, new governance systems to create prudent fiscal policies in future 33

34 Other elements of the euro-nomics plan Two layered banking landscape European banks Regional banks European bank resolution and FDIC Making sovereign default more credible Work in progress stayed tuned to 34