Sovereign debt markets under increased pressureThe European rescue efforts have so far failed to stabilise the financial markets. The ray of light resulting from the French-German pledge of a “comprehensive solution” in October has now gone.
Liquidity is disappearing from sovereign debt markets in otherwise solvent nations. This is making financial conditions tight, which increases the risk of a deep and prolonged recession in Europe.
In our view, and based on evidence from the SMP interventions, the ECB is the only
institution left with a sufficiently large balance sheet, the necessary flexibility and the
speed and decision power to short-circuit the current vicious circle between financial
markets, government debt and a deteriorating growth outlook.
To alleviate the current situation, the ECB is able to take measures to secure the liquidity in sovereign debt markets (sovereign credit easing) and increase the support for economic growth (monetary easing). In fact, this fits the separation principle that the central bank has been advocating for so long. While monetary easing has already begun, there is still no viable strategy on how to restore normal functioning of the sovereign debt markets.
What ECB could do to alleviate the market stress
A number of elements can be considered to restore normal functioning of the sovereign bond markets in Europe. One idea is that the ECB could announce a credible credit easing programme for the sovereign bond markets in solvent countries (we denote it Sovereign Credit Easing Programme, SCEP). Insolvent countries and countries with unsustainable debt dynamics should not be eligible for the SCEP, as this would undermine the credibility of the ECB. Thus, countries currently operating under IMF/EU/ECB programmes such as Greece should not be included before they are back on a sustainable path.
The strategy has to be transparent and designed to minimize political moral hazard by keeping the current reform pressure on national governments in place. We envision that such a strategy could be implemented in the following way:
- ECB announces a cap on individual countries’ yield spread to Germany (or the country within the euro area with the lowest funding cost). The cap should be unconditional for all existing bonds and set below the 450bp margin requirement threshold at London Clearing House (LCH), say at 350 or 400bp. Alternatively the ECB could announce an outright cap on the level of the bond yield.
- To make it work, the ECB would have to announce that it is ready to buy unlimited quantities of government bonds in eligible countries to defend the maximum yield spread. The purchases could, as with the current Securities Market Programme, be sterilized through term deposits or reverse repos. In this sense the SCEP would be an extension of the SMP and not quantitative easing. Therefore this strategy should be viable within the current ECB mandate.
- To keep the reform pressure on solvent countries the SCEP should be conditional for new bond issues. Only as long as governments comply with debt reduction targets and stability programmes as defined by the EU, new bonds issued should be eligible for the SCEP. Given that many countries roll 10-20% of the total debt each year, this should keep incentives in the right place.
- A politically independent body (perhaps the ECB itself) should monitor whether countries comply with debt reduction targets and stability programmes. This agency will decide if new bonds issued are eligible for the SCEP or not.
- Any country not complying with the conditions must either issue outside the SCEP – thereby facing significantly higher marginal funding costs – or be financed through a bridge facility (IMF or EFSF/ESM bridge loan) under strict conditionality. Once the country is back on track it would again be allowed to issue new bonds under the SCEP.
By defining a credible cap on the yield spread for existing bonds, the strategy would short-circuit the current vicious circle in the sovereign bond markets where lower prices lead to more selling. It would improve liquidity and make it easier for countries like Italy and Spain to stay in the market. At the same time it would prevent political moral hazard problems because new bonds are only eligible for the SCEP under conditionality. Finally, the ECB would probably end up buying less government bonds by announcing a transparent and credible strategy, than it would under the current Securities Market Programme.
While this proposal does not address the underlying structural problems of the euro, we believe it would buy some much needed time for European policymakers to define a really comprehensive solution for Europe, by securing the right incentives for national governments in the meantime and improving market functioning. Further, it would imply that countries were put on a sustainable debt path.
If implemented in the right way, this setup could go a long way towards removing the contagion from the debt crisis to the broader financial system by differentiating between existing bonds and new bonds.
Liquidity is disappearing from sovereign debt markets in otherwise solvent nations. This is making financial conditions tight, which increases the risk of a deep and prolonged recession in Europe.
In our view, and based on evidence from the SMP interventions, the ECB is the only
institution left with a sufficiently large balance sheet, the necessary flexibility and the
speed and decision power to short-circuit the current vicious circle between financial
markets, government debt and a deteriorating growth outlook.
To alleviate the current situation, the ECB is able to take measures to secure the liquidity in sovereign debt markets (sovereign credit easing) and increase the support for economic growth (monetary easing). In fact, this fits the separation principle that the central bank has been advocating for so long. While monetary easing has already begun, there is still no viable strategy on how to restore normal functioning of the sovereign debt markets.
A number of elements can be considered to restore normal functioning of the sovereign bond markets in Europe. One idea is that the ECB could announce a credible credit easing programme for the sovereign bond markets in solvent countries (we denote it Sovereign Credit Easing Programme, SCEP). Insolvent countries and countries with unsustainable debt dynamics should not be eligible for the SCEP, as this would undermine the credibility of the ECB. Thus, countries currently operating under IMF/EU/ECB programmes such as Greece should not be included before they are back on a sustainable path.
The strategy has to be transparent and designed to minimize political moral hazard by keeping the current reform pressure on national governments in place. We envision that such a strategy could be implemented in the following way:
- ECB announces a cap on individual countries’ yield spread to Germany (or the country within the euro area with the lowest funding cost). The cap should be unconditional for all existing bonds and set below the 450bp margin requirement threshold at London Clearing House (LCH), say at 350 or 400bp. Alternatively the ECB could announce an outright cap on the level of the bond yield.
- To make it work, the ECB would have to announce that it is ready to buy unlimited quantities of government bonds in eligible countries to defend the maximum yield spread. The purchases could, as with the current Securities Market Programme, be sterilized through term deposits or reverse repos. In this sense the SCEP would be an extension of the SMP and not quantitative easing. Therefore this strategy should be viable within the current ECB mandate.
- To keep the reform pressure on solvent countries the SCEP should be conditional for new bond issues. Only as long as governments comply with debt reduction targets and stability programmes as defined by the EU, new bonds issued should be eligible for the SCEP. Given that many countries roll 10-20% of the total debt each year, this should keep incentives in the right place.
- A politically independent body (perhaps the ECB itself) should monitor whether countries comply with debt reduction targets and stability programmes. This agency will decide if new bonds issued are eligible for the SCEP or not.
- Any country not complying with the conditions must either issue outside the SCEP – thereby facing significantly higher marginal funding costs – or be financed through a bridge facility (IMF or EFSF/ESM bridge loan) under strict conditionality. Once the country is back on track it would again be allowed to issue new bonds under the SCEP.
While this proposal does not address the underlying structural problems of the euro, we believe it would buy some much needed time for European policymakers to define a really comprehensive solution for Europe, by securing the right incentives for national governments in the meantime and improving market functioning. Further, it would imply that countries were put on a sustainable debt path.
If implemented in the right way, this setup could go a long way towards removing the contagion from the debt crisis to the broader financial system by differentiating between existing bonds and new bonds.