princetonpanel_europeandebtcrisis

8/13/2019 princetonpanel_europeandebtcrisis

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Princeton, Oct 24th, 2011


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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


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0

5

10

15

20

25

0

5

10

15

20

25

Jan 94 Jan 97 Jan 00 Jan 03 Jan 06 Jan 09

Germany

Italy

Par Yield

France

Greece

Spain

Source: Eurostat

Eurozone: 10 Y Sovereign debt yield

3


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80

100

120

140

160

80

100

120

140

160

Jan 96 Jan 00 Jan 04 Jan 08

12-Mo. Moving Average HCPI for Eurozone(1999=100)

Germany

Italy

Par Yield

France

Greece

Spain

Source: IMF

Eurozone: Persistent Inflation Divergence

4


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Real interest rate gap

Average rates 99-07 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%

5

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


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Eurozone Accumulated Net Capital Inflows

6

-1200

-1000

-800-600

-400

-200

0

200

400

600800

Q1 1994Q1 1997Q1 2000Q1 2003Q1 2006Q1 2009

Germany

Italy

Billion

France

Greece

Spain

Source: Eurostat


7/18

German Foreign Claims

8

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

Jun.1991

Dec.1992

Jun.1994

Dec.1995

Jun.1997

Dec.1998

Mar.2000

Dec.2000

Sep.2001

Jun

.2002

Ma

r.2003

Dec.2003

Sep

.2004

Jun.2005

Mar.2006

Dec.2006

Sep.2007

Jun

.2008

Mar.2009

Dec.2009

Sep.2010

BelgiumGreece

Ireland

Italy

Portugal

Spain


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-20

0

20

40

60

80

100

1995 1997 1999 2001 2003 2005 2007 2009 2011

Germany

Italy

Percent

France

GreeceSpain

Source: OECD

Belgium

Ireland

PortugalEurozone

Eurozone: Accumulated GDP Growth

9


9/18

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


10/18

Crisis diagnosis 1: Flight to safety


Value of German bund/French debt increases German CDS spread rises, but yield on German Bund drops (flight to safety)


11

1

2

3

4

20

40

60

80

100

120

Apr 11 May 11 Jun 11 Jul 11 Aug 11 Sep 11 Oct 11

German Sovereign 5Y CDS and 10Y Yield

CDSSpread

10Y Yield

Par Yield

Source: Bloomberg

Basis Points


11/18

Crisis diagnosis 2: Diabolic Loop

Contagion due to diabolic loop twin crisis

Banks need risk-free asset for transactions (best collateral)

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Trigger

Bank insolvency

(Ireland, Spain)

Public debt/slow growth(Greece, Portugal, Italy)


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Distortions - Inconsistency

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

Inconsistency

No-bailout clause

Zero risk weight

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13/18

ESBies proposal

1. Create safe asset

With flight to quality correlation structure

Remove pressure for capital flows across borders

channel them across different tranches2. Appropriate risk weights + haircuts for sovereign debt

Break diabolic loop

Part of bigger proposal

European FDIC, bank resolution, etc.

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9 economists: www.euro-nomics.com


14/18

ESBies structure

up to 60% of GDP (5 year average) from all Euro-members

ESBies flight to quality/safety assetcoordination!

Basel: zero weight

ECB: preferred asset to conduct open market operations

No control rights for junior tranche!

15

sovereign

bonds ESBies

Junior tranche

A L


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Flight to safety: in times of crisis


Value of German bund/French debt increases German CDS spread rises, but yield on bund drops (flight to quality)


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

sovereign

bonds ESBies

Junior tranche

A L


16/18

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!

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17/18

Transition phase

Give long-run perspective

Phase in

ESBies (market has to learn about junior tranche)

Increase in capital requirements

Swapexisting holding of sovereign debt for ESBies(at market prices after price adjustment due to ESBies proposal)

Recapitalizationof 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-riding18


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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!

Dont distort incentives for sovereigns Interest rate signal as corrective (market) force should remain intact

Stable credibleand 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 withchange 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

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