Euroland: Market discipline or market instability?

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This post is a guest contribution by Elga Bartsch of Morgan Stanley.

In this note, I discuss the role of market discipline in fostering effective surveillance of fiscal policies in the euro area. This note summarises the remarks that I made at a recent ECB Policy Workshop on EMU Governance. In addition to the issue of market discipline more generally, I look into whether private sector involvement (PSI) is a disciplining or only an unsettling factor. My main conclusion is that the root cause of the current market turbulence is the lack of a lender of last resort. In my view, PSI has been merely a contributing factor, exacerbating contagion across the euro area. It is not the root cause for government bonds being viewed as credit risks though. To restore confidence in euro area government bond markets and to allow market discipline to work better in future, I propose a tiered issuance scheme for government bonds, where only the senior tranche is backed by a lender of last resort and the junior tranche(s) can be restructured relatively easily.

Some view market discipline as a meaningful complementary tool to the political peer review process in order to ensure effective surveillance of fiscal policies. Unfortunately, market discipline does not seem to work well in practice. In the first ten years of the euro, markets underestimated – you could even say completely ignored – the credit risks associated with euro area sovereigns. The underestimation of credit risks is not unique to euro area sovereigns though, and I do not want to discuss the reasons for the past failure to recognise the sovereign credit risks in detail here. However, there is clearly a pro-cyclical element in the overly optimistic risk assessment, aggravated by overly loose monetary policy globally, and a regulatory element due to the zero risk-weighting for government bonds under the Basel II capital requirements. In the euro area, it also might have even been rational for investors to assume that the ‘no bail-out’ clause of the European Treaty would not hold, if put to the test.

Over the last two years, we have seen re-rating of the market perceptions of euro area sovereign credit risks. Today, I would argue, markets significantly overestimate the sovereign credit risks in the euro area. However, what’s more, we have observed a fundamental regime shift in government bond markets. Rather than viewing government bonds as risk-free, safe haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks (see Arnaud Marès, The Economic Consequences of Greece, August 31, 2011). This has very profound consequences for the stability of financial markets, I think. For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, i.e., rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector. This inherent market instability casts some serious doubts about whether markets should be relied upon as a disciplining factor in the fiscal surveillance of euro area member states. Private sector involvement (PSI) was an exacerbating factor in fostering this regime shift. But, in my view, it is not the root cause. I believe that the root cause is the absence of a lender of last resort to governments.

As individual euro area countries do not have access to a central bank as lender of last resort, all member states’ debt instruments are effectively credit risks. True, the bond markets do not view all countries in this way (yet). Germany, at least for now, still seems to be benefitting from a safe haven status. But, this assessment could tilt very quickly if, for instance, Germany and other core countries signed up for ever-larger rescue mechanisms. Just witness the shift in the market perception of France or Belgium at the moment. The absence of a lender of last resort – which, of course, is ruled out by the European Treaty – also implies that even moving towards a fully integrated fiscal union would not remove the credit risk completely (see EuroTower Insights: Fiscal Union Needs Monetary Back-Up to Solve Crisis, September 22, 2011). The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank as a lender of last resort. This recourse ensures that even in very distressed situations government bond investors can rest assured that they will be paid back at par. This is what makes government bonds safe haven assets.

Once aware of the credit risks, financial markets have a tendency to significantly overprice the default risks. Looking at the experience of emerging markets, where we have a sufficient number of empirical observations, we find that in all the cases since the mid-1990s where spreads blew out to more than 1,000bp, in only 20% of cases did a debt restructuring really become necessary to restore debt sustainability. The other 80% of countries actually pulled through without any debt restructuring – though often with the help of an IMF programme (see Cottarelli C. et al. (2010), Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely, IMF Staff Position Note No. SPN/10/12). There are good reasons why the market overprices the risk of default: Defaults are highly disruptive, binary events, which potentially have a big impact on portfolio performance. Around a default, you typically see very sizeable non-linear market reactions, as market liquidity tends to dry up almost completely. Clearly, an unexpected default can also be very detrimental for the career of a portfolio manager who was not mandated to take such credit risks. The steady creep of inflationary pressures, by contrast, is a risk that bond markets typically underestimate. You could even say that inflation is a bit of blind spot for the bond market. Default, by contrast, seems to be a hot button for the bond market. Good, some of you might say. A bit of market discipline is exactly what we need.

Unfortunately, what we observe in euro area government bond markets at the moment is more than just an overshoot in the market’s perception of the default risks. The regime shift from risk-free sovereign debt to credit risk actually makes government bond markets unstable. Arguably, it has caused bond markets to become unable to find a new stable equilibrium. This is because bond yields start to move in counter-cyclical fashion: additional austerity efforts which dampen growth cause bond yields to go up rather than down on the back of the perceived increase in the risk of default. The rising bond yields in turn reduce the sustainability of government debt. Fresh concerns about debt sustainability cause a further rise in bond yields. Sprinkle in a few rating agencies re-running their models with the higher bond yields and concluding that a downgrade is (or will soon be) warranted on the back of a deterioration of debt sustainability, and a vicious circle is set into motion.

Once this vicious circle is in motion, I believe that only outright market interventions can restore stability. I am not stating this lightly. In my view, the SMP forces the ECB onto a very slippery slope and, personally, I do not see how the current EFSF iteration can relieve the ECB of its role in the secondary government bond market any time soon. Under the credit market regime, governments have become highly constrained in their ability to stabilise their economies. This is because they are no longer able to borrow cheaply at the bottom of the cycle, and neither are their commercial banks. In addition, governments are undermined in their ability to backstop the national financial sector if needed in face of the ongoing crisis. Hence, rather than exercising market discipline, markets are likely to push towards a sub-optimal equilibrium where even runs on governments are possible. As a result, even solvent governments can become illiquid very quickly. In my view, no euro area country is safe from the regime shift towards credit. We have seen the sovereign debt crisis meandering around the euro area for more than two years now, and eating its way deeper and deeper into the core of the euro area.

Given the statutory limitations on the operations of the ECB/EFSF, it is very difficult, if not impossible, to simply switch back into safe haven mode. Without a monetary backstop, euro area government bonds will not be considered risk-free assets again – in my view, the US or the UK do not fund cheaply because they are fiscal unions, but because they have a central bank in the background as a lender of last resort. In this context, Germany is probably a historical exception rather than the rule. Either markets never really understood that the Bundesbank was banned from monetising German government debt, or we were just lucky that we did not have a sovereign debt crisis during the reign of the Bundesbank.

PSI is a contributing factor – acting as a fire accelerant fuelling the contagion – but it is not the root cause. Euro area government bond markets switched to the credit regime long before PSI was discussed in policy circles. But, PSI gave the official seal of approval to market expectations that restructuring of the Greek debt was unavoidable. While I actually believe that PSI is desirable to avoid moral hazard, the timing of introducing PSI in the midst of the crisis was clearly sub-optimal. Each time, news on PSI seems to have reinforced contagion and triggered a further escalation of the sovereign debt crisis. Introducing PSI into the debate at the Franco-German summit in October 2010 caused Italy and Spain’s bond market to become more volatile. Introducing it explicitly into the ESM post 2013 in mid-December 2010 caused a further escalation in market tensions in these two countries. Bringing PSI forward to late 2011 as part of a second Greek rescue package was another mistake, I think. Effectively, a minimal haircut that will hardly make a dent in the Greek debt burden now seems to undermine financial stability in the euro area as a whole by tainting an entire asset class – euro area government bonds. Given the u-turns that we have seen on the PSI issue, markets assign little credibility to the political commitment made in late July that Greece will remain an exception, given that previous commitments were broken. Thus, even a small-scale Greek default would now likely have systemic consequences, in my view.

Eventually, the policy debate needs to be about the monetisation of government debt via a democratically mandated backstop. The current situation with the SMP is untenable, in my view. At the utmost, and that is being generous already, the SMP might be acceptable as a bridge in an emergency situation. It must not become a permanent backstop though. At the end of day, the quick fixes that are applied at the moment could be the seeds of a euro backlash later. I believe that governments need to be clear about how they intend to relieve the ECB of its temporary task (and when) or whether they intend to explicitly amend the ECB mandate to include a lender of last resort function. The present muddling-through is the worst of all options, in my view. The ECB’s SMP transforms national government debt into a common euro area liability. From a governance point of view, it would be better if this transformation would take place on the EFSF/ESM balance sheet, where national parliaments can exercise their democratic control function. It would be even better, of course, if national debt was not transformed into a euro area liability at all.

In the right framework, market discipline is preferable to a peer review process in strengthening fiscal surveillance, as even strict fiscal rules do not yield the desired effects. At the national level, fiscal rules get broken all the time (e.g., Germany’s strict golden rule under Article 115 Grundgesetz, Gordon Brown’s looser, informal golden rule or the constitutional rule in Japan which was broken in each of the last 20 years). At the European level, the Stability and Growth Pact was quickly undermined. Hence, even constitutional rules cannot be fully trusted.

For market discipline to work, one needs to remove the systemic elements, i.e., the externalities between sovereign borrowers that we observe at the moment. At the moment, a sovereign will likely default either on all of its debt or not at all. And as an aside, decision-making amid uncertainty shows that economic agents find it difficult to assign the correct probability to low-frequency, high-impact events. This could be achieved by breaking down the fungibility between the sustainable portion of the overall debt stock and the excessive portion of the debt stock. Slicing sovereign debt into different tranches would allow governments to ‘default by degree’, like banks do, for instance. By issuing several different tranches of debt (say ‘senior-sustainable’ and ‘junior-not-so-sustainable’ debt), the prospect of a sovereign default is no longer binary. Such a tiered structure is similar to some of the proposals for euro bonds, e.g., a widely cited Bruegel proposal (see Jakob von Weizsäcker, Jacques Delpla, The Blue Bond Proposal, May 2010) or a similar idea put forward by my colleague, Morgan Stanley’s sovereign economist, Arnaud Marès (see Curing Demotion Sickness, December 6, 2010). Here, the tiered structure is actually applied to national bonds though. Obviously, as a country increases its debt beyond the sustainable level (e.g., 60% of GDP), it would see its marginal costs of borrowing increase noticeably. To make the tiering of government debt even more effective, one could consider making holdings of junior government bonds subject to bank capital requirements on the regulatory side. In addition, the Eurosystem could consider applying differentiated haircuts in its collateral framework to distinguish between the senior and junior government debt.

In addition to limiting the borrowing of euro area sovereigns more effectively, we should also consider excessive lending and its contribution to the crisis. For everyone who has borrowed too much, there is someone who has lent too much. Lenders will often be regulated investors in the core, i.e., current account surplus countries such as Germany or the Netherlands. My sense is that politically a ‘banking union’ with federal oversight and a euro area-wide backstop might be easier to engineer than a ‘fiscal union’ transferring parliamentary sovereignty to the federal level, and I think policy-makers should focus more here. In my view, financial regulation and supervision should be an integral part of an improved governance system of the euro area.

It is in this area that the ECB can exert direct influence, as all euro area banks need to refinance with the Eurosystem. In my view, it should use this influence more pro-actively in the future.

Source: Elga Bartsch, Morgan Stanley, October 7, 2011.

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