Overcoming the crisis

Transcription

1 Princeton, Oct 24 th, 2011

2 Overcoming the crisis backwards induction approach: 1. Diagnosis how did we get there? Run-up phase Crisis phase 2. Give long-run perspective Banking landscape (ESBies, European FDIC, resolution, ) Monetary framework Fiscal coordination 3. Transition to long-run 2

3 Eurozone: 10 Y Sovereign debt 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

4 Eurozone: Persistent Inflation Divergence Mo. Moving Average HCPI for Eurozone (1999=100) Par Yield 160 Greece Spain 140 Italy France 120 Germany Jan 96 Jan 00 Jan 04 Jan 08 Source: IMF 80 4

5 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) Risk charge for sovereign debt = 0 Consequence: larger savings in Germany + capital outflows boost to Spanish economy & inflation Source: Bloomberg 5 year government note indices 5

6 Eurozone Accumulated Net Capital Inflows Q1 1994Q1 1997Q1 2000Q1 2003Q1 2006Q Source: Eurostat Billion Spain Greece Italy France Germany 6

7 Jun.1991 Dec.1992 Jun.1994 Dec.1995 Jun.1997 Dec.1998 Mar.2000 Dec.2000 Sep.2001 Jun.2002 Mar.2003 Dec.2003 Sep.2004 Jun.2005 Mar.2006 Dec.2006 Sep.2007 Jun.2008 Mar.2009 Dec.2009 Sep.2010 German Foreign Claims $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 Belgium Greece Ireland Italy Portugal Spain $0 8

8 Eurozone: Accumulated GDP Growth Percent Eurozone Ireland Spain Greece Belgium Portugal France Germany Italy Source: OECD 9

9 Crisis diagnosis 1: Flight to safety Today: asymmetric shifts across borders Value of German bund/french debt increases German CDS spread rises, but yield on German Bund drops (flight to safety) Value of Italian/Spanish/Greek sovereign debt declines 10

10 Crisis diagnosis 1: Flight to safety German Sovereign 5Y CDS and 10Y Yield Basis Points 120 Par Yield Y Yield 3 Today: asymmetric shifts across borders Value of German bund/french debt increases German CDS spread rises, but yield on German Bund drops (flight to safety) Value of Italian/Spanish/Greek sovereign debt declines CDS Spread Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11 Source: Bloomberg

11 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 risk-free asset for transactions (best collateral) 12

12 Distortions - Inconsistency Sovereign debt is treated as safe asset Basel: ECB: Zero risk-weight (for own sovereign) Low haircut e.g. 10 year Greek bond has 10% haircut Concentration of sovereign risk in banks Inconsistency No-bailout clause Zero risk weight 13

13 ESBies proposal 9 economists: 1. Create safe asset With flight to quality correlation structure Remove pressure for capital flows across borders channel them across different tranches 2. Appropriate risk weights + haircuts for sovereign debt Break diabolic loop Part of bigger proposal European FDIC, bank resolution, etc. 14

14 ESBies structure A L sovereign bonds ESBies Junior tranche up to 60% of GDP (5 year average) from all Euro-members ESBies flight to quality/safety asset coordination! Basel: zero weight ECB: preferred asset to conduct open market operations No control rights for junior tranche! 15

15 Flight to safety: in times of crisis A L sovereign bonds ESBies Junior tranche Today: asymmetric shifts across borders Value of German bund/french debt increases German CDS spread rises, but yield on bund drops (flight to quality) Value of Italian/Spanish/Greek sovereign debt declines With ESBies: Negative co-movement across tranches Value of ESBies tranche expands due to flight to quality Value of Junior tranche shrinks due to increased risk Asset side is more stable 16

16 How to create value? Flight to safety fluctuations are reduced No negative distributional effects away from Greece, Italy, towards Germany in times of crisis Can be used in current transition phase! ESBies liquidity premium in normal times (ex-ante) Estimates: 0.7% in normal times Shared across all euro-members Advantages in crisis times are much larger Especially for peripheral countries! 17

17 Transition phase Give long-run perspective Phase in ESBies Increase in capital requirements (market has to learn about junior tranche) Swap existing holding of sovereign debt for ESBies (at market prices after price adjustment due to ESBies proposal) Recapitalization of banks Now smaller --- but there is no way around it mandated private (to avoid stigma) + public backup Similar to U.S. in spring 2009 after SCAP Has to be done in coordinate fashion otherwise free-riding 18

18 Conclusion: Guiding Principles Reduce flight to safety capital flow fluctuations coordinate on new asset Isolate banks from sovereign risk - avoid diabolic loop Higher risk charges for sovereign debt are essential! Don t distort incentives for sovereigns Interest rate signal as corrective (market) force should remain intact Stable credible and transparent rule for portfolio weights Fixed rule based on easily measurable units (e.g. (lagged) GDP or ECB key) Change require anonymity of parliamentary approval and go along with change in voting power (change in ECB key) Avoid procyclicality Set tranching points conservatively (in good times) in order to have buffer for bad times note that correlation will shoot up in times of crisis! Extra Sweetener for transition phase Take advantage of liquidity premium Not a guiding principle Maximize size of ESBIES tranche 19