A safe sovereign asset for the Eurozone?

Transcription

1 Ad van Riet * A safe sovereign asset for the Eurozone? * Senior Adviser, European Central Bank (ECB) Disclaimer: the views expressed are those of the presenter and should therefore not be viewed or reported as representing the views of the ECB Introduction to the policy panel on Debt overhang and stabilization policies at the conference How much of a fiscal union for the EMU?, organized by ADEMU at the Banco de España, Madrid, May 2017

2 Outline A stable EMU requires a safe sovereign asset that serves as the cornerstone of the financial system in an open capital market; without it, euro area stabilisation policies are constrained. 1. The regime switch of EMU: semi-safe sovereigns 2. The regime switch of the crisis: risky sovereigns 3. The safety trilemma of the Eurozone 4. Stability consequences of the safety trilemma 5. Safe and risky tranches of synthetic eurobonds 6. Concluding remarks 2

3 1. The regime switch of EMU: semi-safe sovereigns By adopting the euro, Member States gave up their monetary policy sovereignty. They became subsidiary governments unable to issue debt in a currency under their own monetary control; their public debt is only semi-safe. European laws tried to secure the fragile status of euro area governments as safe creditors to support an integrated capital market and convergence of bond yields: Maastricht Treaty: no bail-out, no debt guarantees, to support market-based fiscal discipline Stability and Growth Pact: imposed sound fiscal policies subject to EU surveillance EU prudential legislation: financial institutions could treat claims on all Member States as safe by definition without exposure limit Basic idea: all member countries are (to be made) safe creditors. This also gives them the capacity to pursue a countercyclical fiscal policy, if and when appropriate. 3

4 2. The regime switch of the crisis: risky sovereigns But European laws for producing safe sovereign assets out of subsidiary government debt were misaligned with fiscal practice and market perceptions. EU fiscal rules were not rigorously implemented, public debt and contingent liabilities remained high EU prudential rule of zero sovereign risk promoted a search for yield in more risky government bonds across the whole eurozone Markets treated government bonds as information insensitive safe debt; to preserve the euro in a crisis, a member country (and its banks) would have to be bailed out During the euro area crisis investors lost confidence in the sovereign signature of the vulnerable countries; their access to capital markets became very expensive and only option was fiscal austerity. The sudden market panic caused flight to safety to German Bund as the traditional safe haven. However, no incentive for Germany to offset fiscal austerity elsewhere. 4

5 Sovereign credit ratings before and after the crisis From , semi-safe sovereign bonds of all euro area countries were perceived as high-quality and liquid assets. But while S&P raised the credit rating for Spain to the highest level in the mid-2000s, around that time it already downgraded Greece, Italy and Portugal. Sovereign credit ratings of 12 euro area countries, Source: Standard & Poor s. 5

6 The regime switch from semi-safe to risky sovereigns Convergence of sovereign bond yields to German level until mid-2008 was followed by sharply higher spreads in ; renewed convergence after mid-2012 due to confidence-building measures and policy efforts to repair broken promise of safe sovereign debt Government bond yields of the euro area countries, % 50 DE FR ES NL PT GR BE AT IT FI IE 25 DE FR ES NL PT GR BE AT IT FI IE Sources: Datastream and ECB. Note: Ten-year government bond yields of the euro area member countries that joined in 1999 (excluding Luxembourg but adding Greece). Last observation: 30 December

7 3. The safety trilemma of the Eurozone The post-crisis EMU faces a safety trilemma: holding on to a national safe haven (de facto the German Bund) in an open capital market is incompatible with financial integration and euro area stability; one of these features has to be given up. As the EMU s safe asset provider, Germany enjoys cheap financing and the exorbitant privilege of high net returns on investments across the Eurozone. But its risk exposure also implies the exorbitant duty to offer insurance in a crisis, i.e. to maintain its positions rather than return to safe haven. 7

8 4. Stability consequences of the safety trilemma A. Semi-safe government debt constrains the ability of national fiscal policies to support euro area macroeconomic stability: Market scrutiny of information sensitive sovereign debt makes it less suitable for fiscal stabilization purposes Many countries have a post-crisis debt overhang and have to focus on fiscal sustainability to secure refinancing, since investors might again move abroad A fiscal stimulus paid by semi-safe debt may also trigger precautionary private savings (Ricardian effects) More semi-safe debt tightens nexus between weak banks and their subsidiary sovereign, whereas the banking union is still incomplete Contagion of other member countries is an ever-present danger Little scope for positive contribution to euro area fiscal stance without creating new risks for financial stability, unless debt legacy is resolved 8

9 Limited ability to contribute to positive euro area fiscal stance Trade-off between fiscal space and risks to fiscal sustainability of euro area countries (countries with fiscal space are shown in dark green; those in other colours have no fiscal space, but various degrees of deficit/debt sustainability issues; countries in red are subject to the Excessive Deficit Procedure, the chart excludes Greece) Source: ECB calculations based on the European Commission s Debt Sustainability Monitor 2016 and Economic Forecast Winter Note: Risks to fiscal sustainability according to overall assessment by the European Commission of medium-term risks, taking account of level of government debt-to-gdp ratio relative to 60% reference value for the position of each country. 9

10 4. Stability consequences of the safety trilemma B. Segmented government bond and thus financial markets complicate monetary policy in supporting euro area macroeconomic stability Monetary policy in EMU is generally more difficult to calibrate, more complex to pursue and to exit, and more likely to produce side-effects Rising sovereign bond spreads and capital flight after a negative shock results in financial fragmentation and will hamper an even monetary transmission Special rules needed for accepting semi-safe sovereign bonds as collateral in refinancing operations and for emergency liquidity assistance to solvent banks Large purchases of national government bonds require careful design: country allocation by ECB capital key, strict issue and issuer limits, special regime for sharing profits/losses within the Eurosystem Challenges for single monetary policy, in particular at zero lower bound for interest rates when unconventional tools must be employed 10

11 5. Safe and risky tranches of synthetic eurobonds The safety trilemma can be solved by a fiscal union with a euro area treasury that issues eurobonds; this appears not feasible right now. Potential intermediate solution is synthetic eurobonds without debt mutualisation. Create a diversified portfolio of national government bonds and issue two tranches: a junior tranche that carries the sovereign credit risk and a senior tranche designed to be (relatively) safe. The safe eurobond tranche functions as cornerstone of the financial system and attracts safe haven capital flows within EMU but due to contagion in a crisis, the risky eurobond tranches will see big jumps in interest rates which could drive this part of synthetic eurobonds to default. This default risk can be contained by asking banks to hold safe eurobond tranches to break domestic nexus between bank/sovereign credit risk and to reduce systemic risk and/or by member countries issuing GDP-linked bonds with counter-cyclical interest payments that limit and diversify the tail risk of uncontrollable national debt dynamics. Need to remove regulatory bias against structured products, to clarify that (semi-safe) sovereign bonds are safer than private bonds used for securitisation. 11

12 The universe of sovereign bonds in EMU Synthetic senior eurobonds rank high in terms of safety and value and broaden availability of safe sovereign assets; synthetic junior eurobonds rank low and may require extra protection to attract sufficient investor demand SAFETY (red line) high payoff fragile high payoff low payoff (always) (outside crises) (in crises) eurobonds high rating (information-insensitive) VALUE (blue line) synthetic senior eurobonds European supranational bonds German bonds other core country bonds average euro area country bonds fragile high rating (information-sensitive) lowest rating (information-sensitive) most periphery country bonds synthetic junior eurobonds default boundary Cyprus bonds Greek bonds Source: inspired by Holmström (2015) and Golec and Perotti (2015). 12

13 6. Concluding remarks The safe tranche of synthetic eurobonds underpins financial integration and euro area stability without debt mutualisation (unless it becomes too big to fail ). On the margin, more scope for countries to make a positive joint contribution to aggregate euro area fiscal stance without risking fiscal and financial stability. ECB could use them for quantitative monetary operations that transmit equally across a single risk-free yield curve to the whole euro area, and prefer them as adequate collateral pledged by banks in refinancing operations. Germany and other core countries would see the financial benefits from their own safe haven status diminish,... but investing in a common safe sovereign asset reduces their current exposure to country risk and common risky tranche takes over their role as shock absorber Net advantage of sharing a safe sovereign asset could be highest for vulnerable countries. Question of how to address possible moral hazard: make participation conditional on compliance with sound fiscal and structural policies phase out preferential treatment of national government bonds in EU financial law. Thanks for your attention! 13

14 Selected literature Brunnermeier, M.K., S. Langfield, M. Pagano, R. Reis, S. van Nieuwerburgh and D. Vayanos (2016b), ESBies: Safety in the tranches, ESRB Working Paper, No. 21, September. Corsetti, G., L.P. Feld, R. Koijen, L. Reichlin, R. Reis, H. Rey, B. Weder di Mauro (2016), Reinforcing the Eurozone and Protecting an Open Society, Monitoring the Eurozone, No. 2, CEPR Press, London. Cœuré, B. (2016), Sovereign debt in the euro area: too safe or too risky?, Keynote address at Harvard University s Minda de Gunzburg Center for European Studies, Cambridge MA, 3 November. Draghi, M. (2017), Monetary policy and the economic recovery in the euro area, Speech at the Conference The ECB and Its Watchers XVIII, Frankfurt am Main, 6 April. European Commission (2016), Towards a positive fiscal stance for the euro area, Communication COM(2016) 727, Brussels, 16 November. Gelpern, A. and E.F. Gerding (2016), Rethinking the Law in Safe Assets, in R.P. Buckley, E. Avgouleas and D.W. Arner (eds), Reconceptualising Global Finance and Its Regulation, Cambridge University Press, New York, pp Golec, P. and E. Perotti (2015), Safe Asset Demand: A Review, University of Amsterdam, Risk and Macro Finance Working Paper, No. 2, 14 September. Gorton, G.B. (2016), The History and Economics of Safe Assets, NBER Working Paper, No , April. Gourinchas, P.-O. and H. Rey (2016), Real Interest Rates, Imbalances and the Curse of the Regional Safe Asset Providers at the Zero Lower Bound, manuscript, prepared for ECB Forum on Central Banking, June. Holmström, B. (2015), Understanding the role of debt in the financial system, BIS Working Paper, No. 479, January. Praet, P. (2015), Public sector security purchases and monetary dominance in a monetary union without a fiscal union, Speech at the Conference The ECB and Its Watchers XVI, Frankfurt am Main, 11 March. van Riet, A. (2016a), Safeguarding the euro as a currency beyond the state, ECB Occasional Paper Series, No. 173, May. van Riet, A. (2016b), Government funding privileges in European financial law: making public debt everybody s favourite?, Tilburg University, CentER Discussion Paper Series, No van Riet, A. (2017), Addressing the safety trilemma: A safe sovereign asset for the eurozone, ESRB Working Paper, No. 35, February. 14