Policy Brief No 237 Kopf on Restoring Financial Stability Rev

8/13/2019 Policy Brief No 237 Kopf on Restoring Financial Stability Rev

http://slidepdf.com/reader/full/policy-brief-no-237-kopf-on-restoring-financial-stability-rev 1/26

Christian Kopf, CFA, Spinnaker Capital, London. The author would like to thank Daniel Gros and

an anonymous referee for comments and corrections; he retains responsibility for any remainingerrors. Contact: [email protected]

CEPS Policy Briefs present concise, policy-oriented analyses of topical issues in European affairs, withthe aim of interjecting the views of CEPS researchers and associates into the policy-making process in atimely fashion. Unless otherwise indicated, the views expressed are attributable only to the authors in apersonal capacity and not to any institution with which they are associated.

Restoring financial stability in the euro area

Christian Kopf

No. 237, 15 March 2011

Abstract

The pricing of sovereign credit risk is a necessary component of the financial architecture of the European

Monetary Union. However, unnecessarily high and volatile risk premia on government bonds are currentlypreventing effective financial intermediation within the euro area, thereby inhibiting its economic recovery.Several proposals have been made on how these risk premia should be brought down, namely i) permanentpooling of funding through joint bond issuance, ii) temporary liquidity assistance through multilateral funds,iii) debt buybacks using multilateral funds, and iv) debt restructuring.

This paper attempts to evaluate these four proposals. It argues that joint bond issuance will not achieve ameaningful reduction of liquidity premia in the sovereign bond market; these instruments would either createperverse incentives or accelerate the sovereign debt crisis for peripheral Europe. An institution to providetemporary liquidity assistance is a necessary addition to the institutional framework of EMU – there needs tobe an EMF to complement the ECB. Debt buybacks using multilateral funds can be a very useful tool forsolvent countries such as Spain; they can prevent an overshooting of risk premia that could turn a sovereignliquidity crisis into a solvency crisis. A quantitative assessment shows that debt buybacks at market prices areinsufficient to correct Greece’s debt overhang, however. In the case of Greece, a voluntary exchange of existinggovernment bonds into new obligations, complemented by a buyback option at a steep discount to face value,could restore sovereign creditworthiness and allow the private sector to regain market access at acceptableinterest rates. In the absence of such an orderly and controlled reduction of public debt, highly indebted euroarea governments will likely opt to restructure their sovereign debt unilaterally, if they fail to regain marketaccess after several years. This could have unwelcome consequences for financial stability in the euro area,which should be avoided through a creative and cooperative approach to the problem.

Contents

1. Sovereign risk premia are useful price signals within EMU ......................................... 2

2. The current level of sovereign risk premia is threatening financial stability ............. 5

3. E-Bonds are not going to work .......................................................................................... 6

4. Temporary liquidity assistance through multilateral funds is necessary ..................... 9

5. Loans from a European Monetary Fund need to be senior to market debt .............. 12

6. Debt buybacks at market prices could make sense for Spain ..................................... 14

7. Greece should undertake a debt exchange at non-market prices ............................... 16

8. Unilateral debt restructurings are possible, but not desirable .................................... 20



2 | CHRISTIAN K OPF

1. Sovereign risk premia are useful pricesignals within EMU

Since the beginning of the sovereign debt crisis,many politicians and academics have called forforceful policy action to reverse the divergence ofcredit spreads within the euro area. For instance,

Cohen (2010) argues that allowing Greece to funditself at a risk-free rate would turn it into asolvent country again, while allowing risk premiato prevail in European financial markets wouldlead to self-fulfilling sovereign debt crises. Beforeevaluating the feasibility of policy proposalsaimed at lowering risk premia in the euro areaperiphery, it is worth asking whether it isdesirable to move back to the market state thatprevailed in the years before October 2009. Forclose to a decade, there was almost no dispersionamong the borrowing rates of governments in theeuro area. Should politicians, central bankers orregulatory agencies strive to re-establish a marketsetting that would allow the Spanish or the Irishgovernment to borrow at risk-free rates?

To properly guide savings and investmentdecisions, only assets without credit risk shouldtrade at a risk-free rate. This implies that financialmarkets regulation should only try to eliminatecredit risk premia on euro area sovereign debt if

euro area governments cannot default on theirbonds. However, history shows that is clearlypossible for European states to restructure theirpublic debt, and economic theory suggests thatthe introduction of European Monetary Unionhas made sovereign defaults more likely.

Throughout the centuries, countries have oftendefaulted on their public debt. From 1557 to 1882,Spain defaulted 13 times on its sovereign debt.During the 19th century, Portugal defaulted sixtimes on central government obligations, andGreece defaulted four times (Reinhart et al., 2003).The UK restructured its government debt fivetimes between 1749 and 1932, by unilaterallylowering the coupon rates. Between 1841 and1873, ten US states defaulted on their governmentdebt, and three of those states repudiated theirdebts altogether. The US imposed a haircut of40% on federal government debt in 1933 byabrogating the gold clause (Reinhard and Rogoff,2010). Germany defaulted on its external public

debt in 1931, and achieved a write-off of about50% in the London Debt Agreement of 1953(Guinnane 2004).

Since fiat currencies gained prevalence,governments have often resorted to currencydebasement through inflation and depreciation inorder to lower the real value of their debt. Thishas allowed most OECD governments to avoidoutright defaults in the last sixty years, and it hasgiven rise to the belief that sovereign debt crisesin advanced economies are a thing of the past.For the countries of the euro area, however, this isa misguided belief. By adopting the euro,European governments have voluntarily putthemselves into the position of “EmergingMarkets” issuers, and have subjected themselvesto elevated default risk.

In many Latin American, Eastern European andAsian countries, frequent use of the printing pressto finance interest payments on government debt

or the insistence on non-market exchange rates asa means of financial repression made itimpossible for governments to borrowmeaningful amounts in their own currencies. Thiscontributed to the build-up of large amounts offoreign-currency denominated sovereign debt.The resulting currency mismatches on publicsector balance sheets were the main cause of thewave of sovereign defaults that hit “EmergingMarkets” since 1982 (Eichengreen et at. 2005,Goldstein and Turner 2004). In fact, it can be

argued that the presence of sizable liabilities in acurrency that the government cannot control isthe defining characteristic of an “EmergingMarket”. The presence of sizable liabilitiesindicates that the country is indeed a “market”and not shut off from the global economy, andthe fact that these liabilities are denominated in aforeign currency means that the country will besubject to an elevated degree of macroeconomicvolatility, which turns it into an unstable“Emerging Narket” rather than a stable and

“advanced economy”, to use the IMFterminology.

A country with largely foreign-currencydenominated liabilities faced with a “suddenstop” of capital inflows will not be able toaccommodate this balance of payment shock byletting its currency depreciate, as this would leadto an explosion of debt servicing costs on foreign-currency denominated liabilities and triggerlarge-scale private and/or public sector defaults

(Calvo et al., 2003). Instead, the country willtypically have to tighten fiscal policy in the midstof a recession to demonstrate its ability andwillingness to continue servicing its foreign debt,



R ESTORING FINANCIAL STABILITY IN THE EURO AREA | 3

which will likely contribute to a severe economicdownturn. This macroeconomic setting can leadto a self-reinforcing and self-fulfilling sovereigndebt crisis.

“Emerging markets” can therefore be defined ascountries that are unable to run counter-cyclical

fiscal and monetary policies because they rely onforeign-currency denominated debt. Thesecounties regularly suffer from elevatedmacroeconomic volatility. In the good years ofexpanding global liquidity, they attract largecapital inflows at low real interest rates and enjoya credit-funded boom. In the bad years, whencreditors suddenly retract, they find themselvesdeprived of fiscal and monetary policy options tosmooth the decline in output and subject to highsovereign country risk premia, which choke the

economy. Hausmann and Gavin (1996) foundthat the volatility of economic growth rates inLatin America has been more than twice as highas in industrial economies, and the volatility ofprivate consumption growth nearly three timeshigher. Eichengreen et al. (2005) show thatcountries which face difficulty in borrowing intheir own currency exhibit a larger degree ofoutput fluctuations. Allen et al. (2002) argue thatvirtually all financial crises in ‘emerging markets’over past decades have involved currency

mismatches. Schnabel (2004) shows that the highlevel of foreign-currency denominated debtcaused the banking crisis and the sovereigndefault of Germany in 1931.

Policy-makers in Latin America, Eastern Europeand Asia have become increasingly aware of theinherent dangers of running liabilities in acurrency they cannot control. Roughly ten yearsago, they started to eliminate mismatches onpublic and private balance sheets by borrowing in

their own currencies. As a result, countries suchas Brazil, Turkey or Indonesia can probably nolonger be qualified as ’emerging markets’ – theyare now economies with high and relativelystable economic growth. For the first time inabout 30 years, these countries have been able toincrease fiscal stimulus, lower central bank ratesand allow their currencies to depreciate duringthe financial crisis of 2008/2009 without runningthe risk of sovereign default. At the same timethat emerging markets started to eliminate a

major source of macroeconomic vulnerability, thegovernments of Ireland, Spain and Greecevoluntarily entered the European MonetaryUnion and thereby relinquished the ability to

borrow in a currency they can control. The resultis elevated sovereign default risk for thesecountries.

To illustrate this argument, it is useful to comparethe fates of Spain and the United Kingdom. Eachcountry went through a credit-driven real estate

boom in the run-up to the current downturn.Once the bubble burst, economic outputcontracted, unemployment rose and the fiscalaccounts slipped into a large deficit. According tothe latest IMF projections, Spain will be running afiscal deficit of 6.9% of GDP in 2011, and grossgeneral government debt will rise to 70% of GDP.The UK, on the other hand, will be running afiscal deficit of 8.1% of GDP this year, and publicdebt is expected to reach 82% of GDP (IMF2010c). In light of substantially better sovereign

debt indicators in Spain, how can we explain thatfinancial markets assign a probability of 19% to asovereign default over the next five years, butonly a probability of 5% that the UK will resort topublic debt restructuring? The reason is that it isalmost impossible for financial markets toprovoke a sovereign default in the UK, whilethere is a distinct possibility of such an event inany euro area government. If financial marketssuddenly decided to stop funding the UKgovernment, then gilt yields would rise and the

currency would depreciate. But the floatingexchange rate regime implies that for everypound sterling that jittery investors exchange intoforeign currency, a pound sterling will also bebought by other market participants. Moneysupply would remain constant, and the exodusfrom the government bond market would lead toan increase in bank deposits – as long as nominalinterest rates are reasonably high and there are nodoubts about bank solvency. Commercial bankswould then lend to the government at short

tenors, in the absence of safer alternatives, andthere would be no sovereign credit event. Even inthe extreme case of a system-wide bank run, theBank of England could still lend to thegovernment and thereby prevent a sovereigndefault. By and large, this is the reason whyBrazil, with its floating exchange rate regime andlimited stock of dollar-denominated debt, wasable to avoid a sovereign default in 2002(Schwartsman, 2002).

On the other hand, a sudden stop of marketfunding can mechanically lead to a sovereigndefault in Spain or in any other country of theeuro area. The fixed exchange rate implies that an



4 | CHRISTIAN K OPF

exodus of investors from the government bondmarket can lead to a contraction of domesticmoney supply, as investors allocate the proceedsof government bond sales to other countries ofthe euro area. In the absence of market funding,the government won’t be able to borrow from thecentral bank, as monetary financing of memberstates’ government expenditures is prohibitedunder Article 123 of the Treaty on theFunctioning of the European Union (TFEU).When the government then runs out of cash, itwill default on its obligations in the same way an‘emerging market’ such as Argentina would haveto default on its sovereign dollar bonds. Greecegot fairly close to this situation in May 2010,when emergency funding from the IMF and othereuro area countries arrived only two days beforethe redemption payment on a large governmentbond.

Figure 1. Macroeconomic determinants of sovereignCDS spreads (basis points)

Source: IMF (2010a), Figure 1.6.Note: This chart shows the result of a cross-sectionalregression over the 5-year sovereign CDS spreads of 24countries. Estimates on the required fiscal adjustment aredrawn from the IMF Fiscal Monitor, May 2010. Regressionparameters (t-stats): CDS spread = -2.35 (-1.89) currentaccount balance +4.45 (3.08) required fiscal adjustment+4.14 (4.93) BIS bank claims. Adjusted R² = 0.81.

We have shown that by adopting the commoncurrency, euro area governments have subjected

themselves to a high degree of sovereign defaultrisk. Financial markets regulation should fosterthe efficient pricing of this risk. This implies thatmeasures to fully eliminate credit risk premia on

euro area sovereign bonds are misguided, as longas they are not taken as part of an overall changeof the constitutional setting of the euro area thatwould turn it from a federation of sovereignstates into a single nation state.

By and large, markets are now pricing relative

sovereign default risk correctly. The results of arecent IMF study, reproduced in Figure 1, showthat 81% of the cross-country variation insovereign credit spreads can be explained by onlythree macroeconomic factors: the required fiscaladjustment to stabilize government debt, foreignbank claims on the public sector, and the currentaccount position. Large primary deficits andstrong reliance on foreign funding mean thatGreece, Portugal and Ireland command elevatedrisk premia.

This result raises the question of why marketsfailed to price sovereign credit risk adequately inthe run-up to the current crisis. Unfortunately,regulatory policies prevented the market fromdoing its job in the decade from 1999 to 2009.Three factors contributed to this policy failure:

i) European bank regulation put a zero capitalcharge on all EU government debt.Specifically, the Capital RequirementsDirective (EU 2006) states in Annex VI, Part

1, point 1.2.4 that “exposures to MemberStates’ central governments and centralbanks denominated and funded in thedomestic currency of that central governmentand central bank shall be assigned a riskweight of 0%.” This directive has beenadopted into national law by all EU memberstates. It encouraged commercial banks tobuy Greek government bonds at a relativelysmall spread over Euribor, fund them in thewholesale market at Euribor flat and earn an

interest rate margin without any regulatorycapital requirement. The return on equity ofthis carry trade was infinite, which made itvery attractive to ignore any embedded tailrisks.

ii) European regulation allowed investmentfunds to invest up to 35% of their net assetsinto bonds issued or guaranteed by thegovernments of any EU member state. Thisprovision of Art. 22, par. 3 of the UCITS

directive (EU, 1985) encouraged fundmanagers to overweight higher-yielding EUgovernment debt, in defiance of prudentportfolio diversification.




iii) The ECB failed to differentiate for sovereigncredit risk in defining initial margins for itsrefinancing operations.

In addition to these regulatory failures, ratingagencies played an important role in facilitatinglarge-scale lending to risky sovereign issuers in

peripheral Europe. Against hefty fees from theissuers, these agencies were happy to defy basiceconomic logic and to assign AA ratings to thesovereign debt of countries that were runninglarge and unsustainable twin deficits in theirfiscal and current accounts under a fixedexchange rate regime. In this way, they invitedinvestors to contribute to the credit boom.

The resulting lack of dispersion amonggovernment borrowing rates has contributed to

an unsustainable credit boom in the euro areaperiphery. Once the boom came to an end, manygovernments were left with a large debt burdenand/or unsustainable fiscal trajectories. Europeansovereigns have defaulted on their debt in thepast, and by replacing their domestic-currencydenominated debt with euro-denominated debt,governments have put themselves into a situationwhere the market can actually force them intobankruptcy. These developments have increasedthe risk of sovereign defaults in Europe, and this

credit risk is now being priced by governmentbond markets. Contrary to the proposals byCohen (2010) and others, politicians, financialmarket regulators and central banks should nottry to eliminate the pricing of sovereign creditrisk, but rather reform financial market regulationin a way that strengthens warning signals frommarkets in good times. This, however, will beinsufficient to deal with the current financialcrisis the euro area.

2. The current level of sovereign riskpremia is threatening financial stability

Since the onset of Greece’s sovereign debt crisis inOctober 2009, European financial markets are to alarge degree failing to fulfil their role inintermediating between savers and investors.Sovereign spreads of many countries in the euroarea have risen rapidly, notably in Ireland, Spainand Portugal. Due to the strong linkages betweensovereign creditworthiness and bank solvency,problems in the government bond market have

spilled over to the banking sector. Once Greece’sgovernment had lost market access in the spring

of 2010, none of its commercial banks were able tofund themselves in the bond market any more. InSpain, rising sovereign spreads drove up riskpremia on all of the country’s banks by 150 to 330basis points, and even institutions with stronginternational diversification such as BBVA andSantander were hit. The increase in marginalborrowing rates for commercial banks quickly fedthrough to a commensurate increase in thedeposit rates these institutions have to pay inorder to prevent customer withdrawals. Theresulting rise in the overall liability costs ofcommercial banks in turn acts as a constraint oncredit extensions, and increases lending rates forthe non-financial sector of peripheral countries ofthe euro area.

Figure 2 shows the evolution of the average CDS

spreads of liquid non-financial corporateborrowers with investment-grade ratings in Spainand Germany over the past eight years. Thegraph demonstrates that corporate issuers in bothcountries faced diminished market access duringthe financial crisis of 2008 and 2009, andimproving financial conditions following the G-20 meeting in April 2009. Since early 2010,however, the Spanish corporate sector is facingrising borrowing costs due to contagion from thesovereign’s financing problems.

Figure 2. Non-financial corporate CDS spreads inGermany and Spain (basis points)

Sources: Markit, Bloomberg, Spinnaker Capital.Note: This chart shows simple averages of the risk premia onthe nine Spanish issuers and the 30 German issuers that areincluded in the ITraxx Europe Main index.



6 | CHRISTIAN K OPF

Furthermore, financial markets are currentlyassigning a common risk premium on all euroarea government bonds, regardless of thevulnerabilities of individual countries. It is a well-documented phenomenon that the variation ofsovereign risk premia over time can be attributedto such a common factor. In an early paper,Eichengreen and Mody (1998) demonstrated that“market sentiment” plays a dominant role inexplaining changes in credit risk premia on‘emerging markets’ government bonds.Remolona et al. (2008) find that the cross-sectionalvariation in sovereign spreads can largely beexplained by country-specific fundamentalvariables, while the overall level of risk premia isdriven by a common factor related to investorrisk appetite (as proxied, in their study, by thelevel of equity index volatility). Remolona et al.also find statistical evidence for the commonpricing of sovereign debt within geographicalregions, which is due to the fact that investorsassign risk factors not only to countries, but alsoto continents. Figure 3 shows that financialmarkets are presently penalizing sovereign debt

issued by all euro area governments with anelevated risk premium. The inability of policy-makers to re-establish financial stability in theeuro area has resulted in a collective punishmentby markets. In sum, the sudden loss of marketconfidence in the ability of governments toservice their debts is preventing effective financialintermediation between private savings andprivate investments in the euro area. This inhibitsthe economic recovery, and may lead to a self-reinforcing spiral of weaker activity, lower taxrevenues, and even greater doubts aboutsovereign creditworthiness. European policy-makers should act to prevent a de-stabilisingovershooting of markets. The following sectionsevaluate the main policy proposals that have beenmade to restore financial stability in the euroarea, namely i) permanent pooling of fundingthrough E-bonds, ii) temporary liquidityassistance through multilateral funds, iii) debtbuybacks using multilateral funds, and iv) debtrestructuring.

Figure 3. Common regional factors in sovereign CDS spreads (basis points, log scale)

Source: Standard Chartered (2011). Market data and ratings as of January 2011.

3. E-Bonds are not going to work

Since the onset of the European sovereign debtcrisis, many European academics and politicianshave been calling for the issuance of “E-Bonds”that are collectively guaranteed by the

governments of the euro area. These proposalsdiffer in many important details: De Grauwe andMoesen (2009) suggest that euro area memberstates should be enabled to fund themselves

through E-Bonds at the same marginal interestrate they pay on their national debt issues;Edmond Alphandéry (2010) argues that access tothis financing facility should be granted onlyunder strict fiscal and macroeconomicconditionality, etc. The most prominent concept

for E-Bonds was developed by Jacques Delplaand Jakob von Weizsäcker (2010). This “BlueBond Proposal” has become the basis of policy




proposals for collective debt issuance put forwardby Monti, Juncker, Tremonti and other politicians(see Juncker and Tremonti, 2010).

Delpla and von Weizsäcker propose that euroarea member states be allowed to issue sovereigndebt of up to 60% of GDP jointly in the form of

“Blue Bonds” that enjoy seniority over nationaldebt and that carry a joint and several guarantee.Sovereign debt that exceeds this threshold wouldbecome a junior obligation of the state. These“Red Bonds” would continue to carry theindividual credit risk of each member state. Acountry with payment difficulties would then optfor a selective default on the “Red Bonds” in thefirst step, while remaining current on the “BlueBonds”. If the country’s resources turn out to beinsufficient to service these senior obligations,

then the guarantee on the “Blue Bonds” will becalled and the other member states of the euroarea would have to absorb bondholder losses.

The proposal by Delpla and von Weizsäckershows that the basic idea of E-Bonds is to splitsovereign liabilities into senior and juniortranches. In a reduced form, a risky sovereign hasthe present value of future payments to creditorson the asset side of its balance sheet, and thepresent value of its debt on the liability side of itsbalance sheet. The idea is to split the liabilities onthe sovereign’s balance sheet in two: senior “BlueBonds” and junior member state debt. TheModigliani-Miller theorem suggest that, absentmarket distortions, the weighted average interestrate of the “Blue Bonds” and “Red Bonds” shouldbe identical to the interest rate before the liabilitysplit, because there has been no change on theasset side of the balance sheet. In that case, therewould be no merit to the “Blue Bond” proposal.

To illustrate this point, we can consider the

example of Portugal. The country will likely haveaccumulated gross general government debt (d)of 90% of GDP next year (IMF 2010b), and thecurrent market yield on five-year Portuguesegovernment bonds (r) is 7%. If we assume that thePortuguese government splits its governmentdebt according to the proposal by Delpla andWeizsäcker, then it would be left with 60% ofGDP in “Blue Bonds” (dB) and 30% of GDP in“Red Bonds” (dR). If we further assume that “BlueBonds” would trade at the same level as bonds

issued by the European Union under the EFSM,then five-year Portuguese “Blue Bonds” (rB)would yield 2.80%. The present value of

payments made available to sovereign creditorsdoes not change because of this liability split,which implies that we can derive the yield onfive-year Portuguese “Red Bonds” (rR) from d · r

= dB · rB + dR · rR. Under current marketparameters, risk-neutral investors that face nomarket distortions would therefore price five-year Portuguese “Red Bonds” at 15.4%. It is clearthat Portugal would not be able to access theprimary market for “Red Bonds” at such a level.

This example shows that implementing the “BlueBond” proposal would immediately force mostperipheral euro area countries into a partialsovereign default. However, the result relies on anumber of simplifying assumptions. Under whichcircumstances would the liability split lower theweighted average borrowing costs of the

sovereign to an extent that becomes attractive forissuers?

Juncker and Tremonti (2010) believe that theelimination of liquidity premia would lower theweighted average borrowing costs of thesovereign. They argue that “the absence of well-functioning secondary markets” is forcinginvestors to demand an elevated yield onsovereign bonds issued by peripheral countries ofthe euro area and that the introduction of E-Bonds would eliminate the resulting sovereignspreads. It is reasonable to assume that higherliquidity would indeed lower the yield on “BlueBonds”. The interest rate (r) on sovereign debt inthe euro area has three basic components: risk-free Eonia swaps (e), a credit spread (c) thatcompensates investors for the default risk of thatsovereign, and a liquidity premium (l) thatcompensates investors for market volatility. Insum, r = e + c + l. The market quotes r and e, andwe can derive the overall spread (c+l). Although c

and l are unobservable individually, we canassume that l is going to be greater than zero. Juncker and Tremonti argue that splittingsovereign liabilities into a large portion of ultra-liquid “Blue Bonds” and a smaller portion of lessliquid “Red Bonds” will reduce the overallliquidity premium on the stock of debt, andthereby lower borrowing costs. This may be thecase, but the effect is likely to be very small. First, Juncker and Tremonti fail to mention that theliability split would not only lead to the issuance

of “Blue Bonds” with low liquidity premium, butit would also leave the sovereign with “RedBonds”, which would require an even higherliquidity premium. Second, the assumption that



8 | CHRISTIAN K OPF

the entire yield spread of European sovereignbonds over the risk-free rate can be attributed toliquidity premia is clearly false.

Figure 4 shows the spread of ten-year Austriangovernment bonds over German governmentbonds with the same maturity. This spread is a

good proxy for the pure liquidity component insovereign spreads of euro area countries. Itcompares the funding cost of an issuer withprime rating that is tapping the most liquid bondmarket in Europe (Germany) with another issuerwith prime rating that operates in a market withrelatively small trade volumes (Austria). Thefigure shows that yield spreads of Austrian over

German government bonds had almostdisappeared before the onset of the financialcrisis. The spread stood at 47 basis points inFebruary 2011, slightly above the long-termaverage of 21 basis points. If the price ofsignificantly lower liquidity is currently around50 basis points in yield premium for issuers withidentical credit risk, then it follows that the yieldspreads of government bonds issued by Belgium(120 basis points over Eonia), Spain (230 basispoints over Eonia) or Portugal (430 basis points)can largely be attributed to credit risk, and not toliquidity premia.

Figure 4. Liquidity premium on Austrian government bonds

Sources: Bloomberg, author’s calculation. 2971 daily observations, median 6 bps, arithmetic average 21 bps.

This illustration is confirmed by a large body ofempirical research. A detailed study of liquiditypremia in the European government bond marketconcludes that “yield spreads were significantly

affected by liquidity premiums before the start ofEMU [but] this liquidity effect largely vanishedwith EMU” (Bernoth et al. 2006). Using a differenteconometric technique, another study reaches thesame conclusion: “Liquidity differences play atmost a minor role, and this role appears to arisepartly from their interaction with fundamentalrisk” (Pagano and von Thadden, 2004).

We can conclude that a reduction in liquiditypremia could lower the average funding costs of

peripheral countries of the euro area by a smallmargin only, contrary to the assertions of Junckerand Tremonti (2010). Delpla and von Weizsäcker(2010) acknowledge this by assuming a liquidity

premium of 30 basis points only. For mostperipheral euro area countries, this smalllowering of the overall funding costs would stillleave them with double-digit market yields on

“Red Bonds” and the risk of an immediate partialsovereign default.

There is a second reason why a liability splitcould lower the weighted average borrowingcosts of the sovereign: “Blue Bonds” would notonly be senior claims against the member state,but they would also constitute joint and severalliabilities of all euro area member states. Thiscollective guarantee significantly reduces defaultrisk on “Blue Bonds” due to the limited default

correlation of the guarantors, and thereby lowersborrowing costs. Pooling part of the sovereigndebt of euro area member states through theissuance of “Blue Bonds” has the advantage that




these countries would re-gain access to a form offinancing that remains immune to market seizureunder most plausible scenarios. “Blue Bonds”would enjoy higher credit quality and possiblyhigher liquidity than German Bundesanleihen. Ifprivate investors were to sell “Blue Bonds” in aspeculative attack on European bond markets anddeposit the proceeds of these sales with banks,then these same funds would very likely be rein-vested into short-term “Blue Bonds” by commer-cial banks that are in need of safe assets to matchtheir growing deposit base. Thereby, “BlueBonds” would allow euro area governments tocollectively reinstitute control over the currencyin which their liabilities are denominated.

However, the fact that the market won’t be ableto enforce a default on “Blue Bonds” under most

plausible scenarios does not imply that providing joint and several guarantees for these instrumentscarries no risk for the guarantors. Assuming thatall euro area member states would continue tohonour “Blue Bonds” of up to 60% of their GDPduring an economic crisis requires a leap of faith.Euro area member states should be happy togrant seniority to such instruments ex ante, but itwould be very difficult to motivate these memberstates to remain current on almost half of theirdebt stock in a severe economic crisis, in order to

preserve the interest of their European partners.

As Tommaso Padoa-Schioppa put it, the euro is“a currency without a state”. The euro area is nota nation state with a federal government and afederal treasury; it is a group of sovereign coun-tries. This implies that the budget prerogativerests with national parliaments, and nationalparliament will act based on national interest.National parliaments have the power torepudiate national debt, in full or in part. From a

constitutional point of view, it is very difficult forthe European Union or the Eurogroup to infringewith this national prerogative. From the realpolitik perspective, there are many examples of thefailure of attempts by the Union to interfere withfiscal policies of member states:

• Germany and France broke the 3% ceiling onfiscal deficits in 2003, but no sanctions wereimposed.

• Greece underreported its fiscal deficit every

single year, since 2000, and only corrected thenumbers with long delays (Ophranidis, 2010)

– and there was nothing the EuropeanCommission could do about it.

• When the European Commission argued infavour of structural reforms and asset sales inthe second review of the assistanceprogramme for Greece in February 2011, the

government reacted with hostility, statingthat “the behaviour of EU, IMF and ECBofficials was unacceptable. We asked nobodyto interfere in domestic affairs … We onlytake orders from the Greek people.”

This constitutional and political setting impliesthat the Stability and Growth Pact is incompatiblewith the nature of European Union. Memberstates will be happy ex ante to agree on rules andsanctions, but it will be impossible to enforce

these sanctions, because of the budgetprerogative of national parliaments. There is abroad understanding of this problem by now,which explains the desire to effectively replacethe Stability and Growth Pact with national fiscalrules that are founded in member states’constitutions.

This setting also implies that a mutual guaranteefor the public debt of member countries isincompatible with the nature of European Union.Neither the Union nor individual member states

have the constitutional or political power toprevent fiscally challenged states from defaultingon “Blue Bonds” in times of crisis, and fromturning them into direct obligations of theguarantors, i.e. the fiscally prudent countries thatchose to avoid sovereign default.

In sum, we can conclude that a liability split intosenior “Blue Bonds” with a joint and severalguarantee of all euro area governments and junior “Red Bonds” could lower the aggregate

borrowing cost of countries in the Europeanperiphery, but mainly because this constructionwould be based on an illusion of seniority thatcannot be enforced in times of crisis. In the end,member countries that wish to remain current ontheir own obligations may end up having to payfor Portuguese, Greek or Irish sovereign debt.

4. Temporary liquidity assistancethrough multilateral funds isnecessary

We have seen in previous sections that fullyeliminating sovereign spreads is not desirable



10 | CHRISTIAN K OPF

under the current constitutional setting of theEuropean Union, and that a permanent pooling offunding through a liability split into “BlueBonds” and “Red Bonds” would either createperverse incentives or drive fiscally challengedcountries into immediate sovereign default.However, it would be wrong to conclude fromthis that sovereign debt markets should best beleft to their own devices, as many Germanacademics and politicians suggest.

Under the fixed exchange rate regime with opencapital accounts that characterises the euro area,sudden swings in creditor sentiment can lead tosovereign defaults even if a country’s public debtis sustainable in the medium term. Sovereigndefaults are costly both for creditors and debtors,mainly because they typically go in hand with

banking crises. The resulting breakdown indomestic financial intermediation can be quiteharsh – as in the cases of Russia (1998) andArgentina (2001), where the chain of paymentbroke and households and firms partiallyreverted to barter. This led to a severe loss inoutput and employment, which lowered thecountry’s welfare and its capacity to repaysovereign debt. Yeyati and Panizza (2011) showthat countries which become subject to elevatedsovereign default risk typically suffer severe

output contractions, independently of whether ornot the government ultimately decides to validatethe market’s anticipation of a default or not. Theprospect of multilateral liquidity assistance forcountries with sustainable sovereign debt burdencan limit these avoidable output losses andthereby increase welfare. It can act as a catalyst torestore market confidence.

This finding is consistent with the theoreticalliterature on sovereign debt crises. Calvo (1988)

demonstrates in a simple model that thesovereign debt market is characterised bymultiple equilibria. As long as interest ratesremain reasonably low, governments withsustainable debt burdens maximise welfare byremaining current on their obligations. But abenevolent government would chose to(partially) repudiate its sovereign debt if theinterest rate rises too much above the growth rateof the economy. The non-uniqueness of equilibriaimplies that investor expectations of rising

default risk, which are articulated throughelevated risk premia on sovereign debt, canbecome self-fulfilling. Small changes in market

sentiment can drive a solvent country intodefault. Due to the costs of debt repudiation, thissolution to the sovereign debt crisis is a pareto-inferior ‘bad equilibrium’. It follows from thismodel that an international lender of last resortcan help to steer market expectations towards a‘good equilibrium’ – provided, however, that thesovereign’s debt is indeed sustainable. Morrisand Shin (2006) present a game-theoretical modelof sovereign debt crises with three actors: thedebtor country, private creditors, and aninternational lender of last resort. If thesovereign’s cash holdings are smaller than thesum of interest payments and maturing debt inany one period, then “the fate of the country liesin the hand of its short term creditors”, even if thesovereign is fundamentally sound. For annualperiods, this is the case for all member states ofthe euro area. The inefficient outcome of asovereign default can be avoided if aninternational lender of last resort providesliquidity assistance – provided, however, that thesovereign reacts to financial crisis andmultilateral intervention with an increasedmacroeconomic adjustment effort. Thesovereign’s increased effort, in turn, alters theincentives among private creditors and induces adebt rollover.

In her analysis of Germany’s banking crisis andsovereign default of 1931, Schnabel (2004)concludes that “only an ‘international lender oflast resort’ could have provided the ‘liquidity’(foreign currency) needed to prevent the Germancollapse”. This is precisely the reason why theIMF was created in 1944: in a system of fixedexchange rates, there is a need for an institutioncapable of providing emergency funding whencapital markets seize up. The European Uniontoday needs a similar institution; an international

lender of last resort to provide liquidity assistanceto governments of solvent countries that losemarket access, as suggested by Gros and Mayer(2010).

Haufler et al. (2011) disaffirm the need for apermanent facility to support countries facingliquidity crises. They believe that “states thatneed the rescue fund because their creditors arenot convinced that they merely face a liquiditybottleneck must then be considered insolvent.”

As shown above, equating illiquidity withinsolvency ignores key findings of the theoreticalliterature on sovereign debt crises. Shifts in




creditor expectations and creditor coordinationfailures can drive solvent sovereign borrowersinto a default on their obligations, especially ifthese obligations are denominated in a currencythat that sovereign does not control. Furthermore,there is ample empirical evidence oninterventions of international lenders of lastresort in sovereign debt markets that havesuccessfully prevented liquidity problems fromturning into solvency crises: the joint assistance ofthe IMF and the US Treasury to Mexico in 1995,the IMF programme for Turkey in 2002, the jointEU-IMF assistance programmes for Hungary,Latvia and Romania in 2008, to name but a few.In all of these cases, the recipients of multilateralliquidity assistance were able to regain marketaccess and remain current on their debt withouthaving to resort to sovereign defaults. Romaniahad gross general government debt of 21.3% ofGDP (IMF 2010c) when it was hit by contagionfrom the global financial crisis in 2008 and had torequest multilateral liquidity assistance to avoid asovereign default. Arguing that this request forliquidity assistance automatically implies that thecountry “must then be considered insolvent”without giving consideration to fundamentals, asHaufler at al. suggest, is bordering on theridiculous. By turning a blind eye to theoretical

findings and empirical evidence, the authors arefollowing the example of the Bank of England,which denied liquidity assistance to the GermanReichsbank in 1931 and thereby contributed tothe most devastating sovereign default andbanking crisis that shook Germany in the pastcentury.

This is not to say that sovereign debtrestructuring should be avoided at all times. Butthe empirical evidence suggests a limited need tocomplement liquidity assistance with haircuts on

private creditors in order to overcome fiscal andbalance of payment crises. Bini Smaghi (2010)calculated that out of 113 IMF supportprogrammes over the last 20 years, only 19countries defaulted or restructured their debts.

Others have argued that European countriesshould leave the task of providing emergencyassistance to the IMF instead of setting up theirown lender of last resort. However, the sumsinvolved in backstopping euro area sovereign

issuers far exceed the lending capacity of the IMF.This can be illustrated by taking a closer look at

the public sector borrowing requirements invarious European countries.

One of the key lessons from the crises in Asia andin Argentina is that multilateral financialassistance in the context of a fiscal adjustmentprogramme needs to be sufficiently large to take

the country out of the market for two or threeyears – otherwise, the intervention will likely lackcredibility. Emergency funding in fiscal crisesaims to remove the tail risk that a solvent countryhas to default on its sovereign debt because itruns out of cash. As long as this tail risk persists,it can be rational for investors to stop refinancingsolvent countries, to sell down their exposure orto put on “short” positions, because the value ofthese claims will decline further as the sovereignmoves closer to a default. If international

liquidity assistance is provided at small scale,then these funds will likely end up being used tofinance capital flight only, as in the cases ofRussia in 1998 or Argentina in 2001. Onlyprogrammes that cover the sovereign’s grossfinancing requirements well in excess of one yearwill be large enough to contribute to ameaningful reversal of private capital flows. Sucha programme has the potential to remove the tailrisk of an unnecessary default, and therebyinduce the private sector to resume lending to

and investing in the country. For the countries ofthe euro area, the IMF is unable to provide theneeded liquidity assistance on its own. IMFstand-by arrangements are typically capped at500% of quota. In the case of Greece, the IMF tookthe exceptional step of providing €30 billion,which amounts of 3,200% of quota. At present,five out of 27 member states of the EuropeanUnion have obtained credit from the IMF. Table 1shows that the total size of IMF commitments tothese countries is within a range of 10% to 14% of

GDP. The total size of multilateral assistanceprogrammes has varied between 16% and 48% ofGDP, and co-financing through the EuropeanUnion, the euro area or other lenders hasamounted to 35% to 77% of the total programmevolume. Programmes have been sized to coverthe government’s gross financing requirement foreighteen months to three years. The Latviaprogramme went significantly beyond thismetric, as it was primarily a balance of paymentsassistance programmes meant to smooth theadjustment of the excessive current accountdeficit.




Table 1. Actual and potential assistance programmes in the European Union

Sources: IMF, European Commission, Bloomberg, author’s calculations.Note: SDR are converted into EUR using an exchange rate of 1.13. Three-year financing requirements are calculated from the(assumed) programme inception onwards: 2009-2011 for Hungary, Latvia and Romania, 2010-2012 for Greece, 2011-2013 forIreland, Portugal and Spain. For existing programmes, GFR are taken from various IMF staff reports. For potential programmes,GFR are calculated based on Bloomberg data on debt maturities and on government deficit targets under the excessive deficitprocedure of the EU’s Stability and Growth Pact.

The table also shows that under reasonableassumptions, existing funds in the differentassistance facilities are barely sufficient to

backstop Portugal and Spain, if needed. The EFSFcan borrow up to €255 billion while maintainingits AAA rating and the EFSM can borrow up to €60 billion. €40 billion of these funds have alreadybeen committed to Ireland, which leaves €275billion in available lending capacity. If we assumethat IMF commitments to Portugal and Spainwould be capped at 14% of GDP, then theEuropean financial assistance could becomplemented by €171 billion in IMF credit, for atotal assistance volume of €446 billion. A credible

multilateral intervention should cover around80% of the cumulative gross financingrequirement of the public sector in the first threeyears of the programme, which would amount to €410 billion for Portugal and Spain combined.

In sum, an institution to provide temporaryliquidity assistance is a necessary addition to theinstitutional framework of EMU. This role cannotbe assumed by the IMF alone, due to the size ofthe necessary interventions. There is a need for a

European Monetary Fund (EMF), as suggested byGros and Mayer (2010), to complement theEuropean Central Bank.

5. Loans from a European MonetaryFund need to be senior to market debt

In the previous section, we have not covered themost common objection against multilateralemergency funding to sovereign borrowers: thisliquidity assistance is said to create ‘moralhazard’ in the sense that it induces governmentsto borrow beyond their sustainable debt level,because they expect that they (or rather, theirprivate creditors) would be ‘bailed out’ bymultilateral lenders if markets seize.

It is clear that any insurance mechanism is proneto moral hazard. The only way to fully eliminatemoral hazard in multilateral lending tosovereigns would be to stop providing suchinsurance against market seizure. This, however,would imply that euro area governments shouldhold no public debt at all. Experience withcountries that borrow in a currency they cannotcontrol has shown that markets can seize up forreasons that are unrelated to a country’sfundamentals (such as occurred during theRussian crisis of 1998 or the global financial crisisof 2008) and that markets can drive into defaultsovereign issuers that have perfectly sustainabledebt levels. An example of this is the case of

Existing programmes Potential programmes

in € billions, unless noted otherwise Hungary Latvia Romania Greece Ireland Portugal Spain

IMF quota 1.2 0.1 1.2 0.9 0.9 1.0 3.4

2010 GDP 98.4 17.8 121.7 229.9 156.5 171.4 1051.3

Three‐

year

cumulative

public

sector

financing

requirements,

from

programme

inception

onwardsPrincipal amortisations 42.1 0.3 4.3 97.2 62.9 46.3 288.5

Projected net borrowing 5.9 2.3 13.3 73.4 42.4 21.0 157.1

Gross financing requirement (GFR) 48.0 2.5 17.6 170.6 105.3 67.3 445.6

(Potential) IMF credit 12.5 1.7 12.9 30.0 22.5 24.0 147.2

(Potential) IMF credit, in % of quota 1065% 1186% 1108% 3226% 2375% 2448% 4272%

(Potential) IMF credit, in % of 2010 GDP 13% 10% 11% 13% 14% 14% 14%

EU co‐financing 6.5 3.1 5.0 80.0 40.2 29.8 209.3

Other co‐financing 1.0 2.7 2.0 0.0 4.8 0.0 0.0

Total programme 20.0 7.5 19.9 110.0 67.5 53.8 356.5

Co‐financing, in % of total programme 38% 77% 35% 73% 67% 55% 59%

Total programme, in % of GDP 20% 42% 16% 48% 43% 31% 34%

Total programme,

in

%

of

public

sector

GFR 42% 295% 113% 64% 64% 80% 80%




Romania, which lost market access in 2008,although it had government debt of merely 21.3%of GDP. In the two-period model of Morris andShin (2006), the market can drive a sovereign intodefault if its cash holdings are smaller than thesum of interest payments and maturing debt inany one period. Extending this game-theoreticalexercise beyond two periods would show that asovereign which is borrowing in a currency itdoes not control needs to hold cash well in excessof its gross financing requirement for one year inorder to be protected against market seizure. Thisraises the question of why such a governmentshould borrow at all, since holding 40% or 50% ofits credits in cash reserves would most certainlyrender any borrowing uneconomical. Indeed, theresult of the sovereign defaults of US states in the1840s was that most states stopped borrowing inmeaningful size, and that most state constitutionsnow require balanced cash budgets. The absenceof a robust international lender of last resort inthe Asian crisis of 1997 led to a massiveaccumulation of international reserves which hasturned almost all Asian sovereigns from netdebtors into net creditors. Opponents ofinsurance mechanisms to protect euro areamember states against market seizure implicitlyargue that these countries should have no public

debt at all. If, however, euro area member statesare unable to borrow and there is no meaningfulfederal budget at the level of the European Union,then macroeconomic volatility should beexpected to rise significantly, as governments areno longer in a position to smooth aggregatedemand over time. This problem is exacerbatedby the fact that monetary policy in the euro areacannot be expected to react to asymmetric shocksthat hit individual member countries. Risingmacroeconomic volatility due to inadequate fiscal

and monetary policy responses to fluctuations inoutput is associated with welfare losses. There arethree options to avoid such welfare losses:

i) EMU breaks up and member states revert toa situation in which they are able to borrowin a currency they can control,

ii) EMU is transformed into a full transfer unioncomparable to the USA, where member statesdon’t borrow and hold no debt, but a largeportion of overall taxes flow to the federal

government, which issues debt to smoothaggregate demand,

iii) EMU member states keep their sovereigndebt, and an insurance mechanism is put intoplace to protect them against market seizure.

If member states of the euro area indeed opt to setup a European Monetary Fund (EMF) as a jointinsurance mechanism against market seizure,

then they should look at ways of reducing moralhazard within this institutional framework,instead of embarking on the elusive quest ofeliminating moral hazard altogether. The bestway to minimize moral hazard in multilaterallending to sovereigns is to insist on seniority overmarket debt.

Countries can lose market access for two reasons:market failure could lead to a liquidity crisis, orexcessive debt could lead to a solvency crisis. This

leads to a dilemma for multilateral lenders: it isdifficult to tell these two types of crises apartwhen markets seize. The sustainable debt burdenof a sovereign is not clearly defined, and liquiditycrises can turn into solvency crises when highmarket interest rates result in prohibitive debtservicing costs, as explained by Calvo (1988).However, emergency funding through aninternational lender of last resort can only be justified in the context of market failure and aliquidity crisis. If there is no market failure, then

there is no reason for public interventions infinancial markets. Emergency funding that isprovided to a solvent lender can act as a catalystto re-start private lending and thereby help tosteer the market to a ‘good equilibrium’.However, emergency funding provided to acountry which is actually facing a solvencyproblem that has been correctly diagnosed bymarket participants will only serve to bail outreckless lenders.

Fortunately, there is a way out of this dilemma:

seniority of multilateral lending. The IMFtypically provides emergency funding in limitedsize, for a limited time and at concessional terms.If the country manages to regain market accessafter being granted liquidity assistance and paysback its multilateral credits, then this is a sign thatit was only facing a surmountable liquidity crisis.If the country fails to regain market access, thenthis is a signal that it was facing a solvency crisisand has to bring down its debt overhang. In thatcase, IMF seniority will prevent a waste of thelenders’ resources. Seniority of funding isinstrumental in preventing moral hazard bylimiting the risks for the multilateral lender: IMF




buyback operations in the early 1990s.Commercial bank creditors were given the choiceto convert their existing Philippine sovereignbonds into Brady bonds or to tender them forcash, at 52% of face (Chemical Bank, 1992). Theoptions were calibrated to achieve identical netpresent value. Buybacks were largely financed bynew loans from the World Bank and the IMF.Documents retained by Citibank show that thePhilippine sovereign debt restructuring achieveda participation rate of 96% of outstanding debt.Holders of 27% of eligible debt chose the buybackoption, and holders of 69% of eligible debt optedfor an exchange into new sovereign obligations.Sovereign spreads quickly receded once the debtrestructuring was completed.

Debt only trades at a significant discount to par if

creditors assign a high probability to non-payment. If countries retire debt at a discountthey won’t have to pay back the full amount oftheir borrowing at maturity, even if they doremain current on their obligations. Krugman(1988) shows in a simple model that sovereigndebt buybacks at a discount reduce the expectedtotal payments to all creditors, as they deprivecreditors of the option value of full repayment. Asa result, “the country gains at creditors’ expense”.Krugman concludes that creditors will typically

not allow buybacks, unless they assign a very lowoption value to full repayment because they areconvinced that the country will default anyway.In that case, a debt restructuring may be morestraightforward. Krugman’s model may explainwhy debtors have often been prohibited fromrepurchasing their own obligations at a discountunder sovereign loan and bond documentation.But in the European case, there are no legalimpediments against sovereign debt buybacks –in fact, the governments of Hungary and Portugal

have carried out several buyback operations inrecent months to restore market order. In anarrow sense, governments may have gained atcreditors’ expenses from these buybacks, asKrugman suggests. But in a broader sense,buybacks may have been pareto-efficient, as theyhave helped to prevent an overshooting of marketrisk premia.

Bulow and Rogoff (1988) argue that sovereigndebt can only be bought back at a significant

discount when the country’s actual paymentcapacity is very low. In that case, the countrywould likely have alternative uses of its scarce

resources that have a higher value for it than debtrepurchases. Dornbusch (1988) criticises that thiscost-benefit analysis “oversimplifies the issue”. Ifadditional resources are made available to adistressed sovereign borrower that are earmarkedfor market-based debt reductions, then thecountry should clearly take advantage of the factthat its debt is trading at a discount to par andrepurchase it from creditors, in order to benefitfrom lower total debt servicing costs. Bulow andRogoff acknowledge this criticism by givingqualified support for market-based debtreduction schemes: “for a buyback to make sensefor a country, it must ... receive incremental newloans and grants to cover part of the cost.”

We conclude that debt buybacks at market pricesmake sense for solvent borrowers that have been

given access to additional resources to carry outthese operations.

Under current circumstances, this may be ofparticular relevance for the Spanish sovereign,which appears to be solvent according to mostmetrics. The Spanish government bond markethas been hit by contagion from the escalatingsovereign debt crisis in Greece, as Figure 5demonstrates. Based on Granger-causality tests, itcan be shown that the widening of Spanishsovereign bond spreads that occurred in early2010 has largely been driven by the CDS market(Fontana and Scheicher, 2010). This is an indicatorfor a speculative attack by leveraged investors.Indeed, anecdotal evidence suggests that manyhedge funds generated handsome profits fromshort positions in Spanish sovereign debt during2009 and 2010. Price signals in the CDS markethave fed through to the government bondmarket, and seem to have triggered an exodus ofmutual funds, pension funds and insurance

companies from Spain. According to proprietaryflow data from European investment banks, theretreat of international investors acceleratedsharply during the fourth quarter of 2010.Anecdotal evidence suggests that major Europeaninstitutional investors have underweighted Spainvis-à-vis their benchmarks, if they hold anypositions at all. Initially, this investor positioningdoes not necessarily reflect a view on thesolvency of the Spanish government. Instead, itcan be rational to ‘short’ Spain, outright or

against a benchmark, if investors expect others tosell as well. The seminal paper on this type ofnoise trading cites Keynes to illustrate this point:




Investment based on genuine long-term expec-tation is so difficult ... as to be scarcely practicable.He who attempts it must surely ... run greaterrisks than he who tries to guess better than thecrowd how the crowd will behave. (DeLong et al.,1990).

Figure 5. Custodial bond flows, 2007 – June 2010, as percent of 2010 general government debt

Source: IMF (2010b), Figure 1.9.

Investor re-positioning and the resulting changesin borrowing rates are necessary components ofwell-functioning sovereign debt markets.However, under a fixed exchange rate regimewith open capital accounts, a speculative attack

on a government bond market can lead to a self-reinforcing sovereign debt crisis. In suchcircumstances, there is a case for sovereign debtbuybacks to prevent the market from becoming aone-way street. Buybacks at a discount to parwould be beneficial for the issuer, and they couldhelp restore market order, in a similar way toautomatic ‘circuit breakers’ that have beenestablished by many stock exchanges.

At present, European policy-makers havedelegated the task of stabilising government debt

markets to the ECB. However, the SecuritiesMarkets Programme brings the ECB dangerouslyclose to monetising government debt, as Weber(2010) and others have rightly criticised. Instead,giving a solvent country like Spain access to EFSFfunds of €50 billion or €100 billion to buy back itsown government debt in the market would allowthe ECB to disengage from quasi-fiscal policy.Expectations of such large-scale asset purchaseshave already deterred speculators andcontributed to a meaningful tightening of Spanish

sovereign spreads and to a lowering of auctionyields in the first weeks of 2011.

In sum, allowing the EFSF to finance sovereigndebt buybacks of solvent euro area membercountries could mark the turning point in theEuropean sovereign debt crisis.

7. Greece should undertake a debt

exchange at non-market prices

For solvent countries, sovereign bond buybackscan serve to restore market order. Beyond thisfunction, buybacks have been proposed as ameans of eliminating the debt overhang thatsome countries in the periphery of the euro areamay be facing.

Gros and Mayer (2011) have proposed such amarket-based debt reduction scheme for euroarea member states that are insolvent accordingto most metrics, such as Greece. In the first stageof their concept, private creditors would beallowed to exchange Greek government bondsinto EFSF obligations at market prices. In order tobe able to harvest the full market-implied debtreduction, this swap offer would be based onmarket prices that prevailed prior to theannouncement of the debt management exercise.The EFSF would then sell its holdings of Greekbonds on to the sovereign, and provide it withcredit at concessional terms to finance thebuyback. As a result, the EFSF would become themain lender to Greece, and private creditors




would have been given an exit, at a market-baseddiscount to par.

Several objections have been raised against thisproposal for “debt reduction without default”.Most notably, the Bundesbank (2011) warns thatdebt buybacks in the secondary market may be

insufficient to restore fiscal sustainability for euroarea governments, because markets are notpricing in a steep enough discount to par value.In the case of Greece, this criticism appears to bevalid.

Table 2 shows the economics of a debt buybackaccording to the mechanism proposed by Grosand Mayer (2011). The current stock of Greece’sbonded debt amounts to €285.7 billion face value,and bonds traded at a market-cap weightedaverage price of 77.5% in February 2011. Theaverage coupon rate that Greece pays on this debtis 4.26%, and the annual interest bill on thisportion of public debt is €12.2 billion. In order tobuy up all bonded Greek public debt at currentmarket prices, the EFSF would have to spend

€221.5 billion (plus accrued interest). The EFSFcan then sell these bonds on to Greece andprovide Greece with a credit of €221.5 billion tofinance the buyback. The EFSF is currentlyfunding itself at a spread of eight basis pointsover euro swaps. Ten-year euro swaps arecurrently trading at 3.52%. Because of over-collateralisation and cash reserve requirements,the EFSF would be able to provide Greece withten-year loans at a minimum rate of roughly4.00%. If a debt exchange were carried out underthese parameters, then Greece would henceforthonly face the EFSF as a creditor, apart from theemergency loans provided by other euro areagovernments and the ECB. Greece would have anannual interest bill of €8.9 billion on its stock ofEFSF debt, provided that the debt exchangeachieves a participation rate of 100%. This impliesthat such a market-based debt reduction wouldlower Greece’s annual public debt service by amaximum of 23%, and take it to around 5.0% ofGDP.

Table 2. A market-based restructuring of Greece’s sovereign debt

in € billions, unless otherwise noted Today Post restructuring

Stock of bonded debt 285.71 221.48

Average coupon rate 4.26% 4.00%

Average bond price 77.5%

2011 interest payments on bonded debt 12.18 8.86

2011 interest payments on IMF and bilateral loans 2.38 2.38

2011 total interest payments on public debt 14.56 11.24

2011 debt service, in % of GDP 6.5% 5.0%

Change in debt service -23%

Sources: Bloomberg, author’s calculations

Note: This calculation is based on instrument-level data on 7 T-Bill issues (€8 billion total notional), 46 domestic bonds(€258 billion total notional) and 29 bonds issued under international law (€19 billion total notional). Bond prices are basedon closing levels as of 2 February 2011. Debt service on IMF and EU loans is estimated based on IMF data.

With this result at hand, we can ask whether amarket-based debt reduction scheme wouldlikely be sufficient to restore debt sustainabilityfor Greece. Figure 6 provides a cross-sectionalview of the public debt service of majoreconomies. It seems reasonable to assume that thegovernment of an advanced economy can sustain

a debt service of around 4% of GDP. This is whatTurkey is paying today and has been paying onaverage over the past decade. In order to service

its current stock of debt, the Greek governmentwill have to pay interest of 6.5% of GDP in 2011,and this burden is projected to increase further inthe years ahead. Combined with the fact thatmost of Greece’s public debt is held by non-resi-dent investors, this appears to be unsustainable.A market-based debt reduction could potentially

lower Greece’s public debt service to around 5.0%of GDP, and it would at best take Greece’s publicdebt burden to around 134% of GDP by the end




of 2011. As the country would still be running asubstantial current account deficit, this amount ofdebt reduction would seem to be insufficient torestore investors’ confidence in the sustainabilityof Greece’s public finances. Investors would

continue to demand elevated risk premia forGreek government bonds in the primary market,and the associated borrowing rates would lead toa snowballing of Greece’s debt servicing costs inthe years ahead.

Figure 6. Government debt affordability (projections for 2011)

Sources: IMF, Moody’s, author’s calculations.

Gros and Mayer (2011) acknowledge that avoluntary exchange of government bonds intoEFSF debt may be insufficient to restore debt

sustainability, as the market discount is too small.In that case, they propose that the EFSF wouldcharge Greece a lower interest rate, in return forthe issuance of GDP warrants that would allowthe EFSF to participate in a better-than-expectedfuture performance of the Greek economy. Itwould certainly be possible to calibrate theinterest rate on multilateral loans in a way thatresults in a sustainable debt burden for Greece –for instance, taking the interest rate to 2% wouldlower Greece’s annual debt service on bonded

public debt by 64%. Under this scenario, Greecewould end up with public debt service of around3% of GDP, which should be a sufficientreduction under most plausible assumptions.However, allowing Greece to fund itself at such aconcessional rate would result in a negative netinterest margin for the EFSF or its successorinstitution, the ESM. This would most certainlytrigger significant rating downgrades, and wouldmake it impossible for the EFSF to raise sufficientfunds in the market to provide Greece with loansto finance a bond buyback. Alternativemechanisms can be designed to provide Greecewith concessional loans in order to carry out bond

buybacks at market prices. But if such highlyconcessional loans are required in order toachieve a sustainable debt burden, then the

international community will rightly ask why itshould finance what is effectively a transferpayment to Greece’s private creditors.

In sum, the relatively low discounts that themarket applies to Greek government bondseffectively rule out a market-based debt reductionscheme along the lines of the proposal developedby Gros and Mayer (2011). However, these lowdiscounts are not a binding constraint on asuccessful debt exchange. After all, current

market prices on government bonds issued bycountries in the periphery of the euro area areartificially high because of ECB purchasesthrough the Securities Market Programme.Instead of starting with current market prices andthen adjusting the EFSF funding rate down inorder to achieve a sustainable debt burden forGreece, as Gros and Mayer suggest, we can startwith a view on the sustainable debt burden forGreece, and then calculate the discount ongovernment bonds that is required to achieve this

debt burden.If we assume that Greece can afford to payinterest of 3.5% of GDP on its public debt under

Portugal Greece

Spain Turkey

Italy

JapanGermany

Norway

‐15%

‐10%

‐5%

0%

5%

10%

15%

20%

0% 1% 2% 3% 4% 5% 6% 7% 8%

C/A balance, in % of GDP

General government interest payments, in % of GDP




most plausible scenarios and that nominal GDPwill reach around €224 billion this year, then wecan set the sustainable total public debt service at €7.84 billion, which is 46% below the currentlevel. Interest payments on IMF loans will likelyamount to around €0.44 billion in 2011 which

leaves roughly €7.40 billion in payment capacityon other public debt. At a coupon rate of 4%, thispayment capacity can sustain a debt stock of €185billion face value of private sector and bilateraldebt. Table 3 gives a summary of this calculation.

Table 3. A restructuring of Greece’s sovereign debt at below-market prices

in € billions, unless otherwise noted Today Post restructuring

Stock of bonded debt 285.71 185.00

Average coupon rate 4.26% 4.00%

Stock of bilateral loans 32.08 nil

2011 interest payments on bonded debt 12.18 7.40

2011 interest payments on bilateral loans 1.94 nil

2011 interest payments on IMF loans 0.44 0.442011 total interest payments on public debt 14.56 7.84

2011 debt service, in % of GDP 6.5% 3.5%

Change in debt service -46%

Sources: Author’s calculations.Note: This calculation assumes that bilateral loans provided by member states of the euro area underthe inter-creditor agreement of May 2010 are restructured into new Greek government bonds.

In order to reduce its current stock of bondeddebt and bilateral loans to a sustainable level of

around €185 billion, the government of Greececould make a voluntary exchange offer. Holdersof government bonds could be given a menu ofthree options:

i) Discount bond option: Holders can chooseto exchange every €1.00 million face ofexisting bonds into €0.58 million face of newbonds, with a coupon rate of 4% and amaturity of 20 years. At an exit yield of 6%,these bonds would have a market value of

€0.45 million. Holders should be offeredcomplimentary GDP warrants with a marketvalue of around €0.10 million for every €1.00million tendered. These GDP warrants wouldallow them to participate in a better-than-expected future performance of the Greekeconomy, as suggested by Gros and Mayer.

ii) Par bond option: Holders can choose toexchange every €1.00 million face of existingbonds into €1.00 million face of new bonds,

with a coupon rate of 1.20% and a maturityof 20 years. At an exit yield of 6%, thesebonds would have a market value of €0.45million as well. Participating holders should

also be offered complimentary GDP optionsworth €0.10 million. The par bond option

should be particularly attractive tocommercial banks that are holding Greekgovernment bonds in their banking books,where these instruments are not subject tomark-to-market requirements.

iii) Buyback option: Holders can choose to selltheir existing bonds to the EFSF at a price of45% of face value. The EFSF would then sellthe bonds on to the Greek government andprovide it with credit to finance the debt buy-

back, as proposed by Gros and Mayer.Holders who decide voluntarily to sell theirbonds in this cash tender should not beoffered GDP warrants; instead, theseinstruments should be issued to the EFSF.

The above proposal is very similar to thesovereign debt restructuring undertaken by thePhilippines in 1992, which was discussed insection 6 of this paper. There are two maindifferences between this approach and the

market-based debt reduction scheme proposed byGros and Mayer (2011): First, the buyback andexchange of existing debt would not be carriedout at market prices, but at a discount that is




sufficient to restore public debt sustainability forGreece. Second, the design of the exchange offerwould ensure that the large majority of privateholders of Greek government bonds would likelychoose to exchange their holdings into newobligations instead of tendering them for cash, inorder to preserve the option value ofparticipating in a future economic recovery ofGreece. As a result, much of Greece’s debt shouldbe expected to remain in private hands after theexchange. This outcome is preferable to asituation in which Greece would only borrowfrom the EFSF, the IMF and other euro areagovernments, as proposed by Gros and Mayer(2010).

The proposal is structured as a voluntary debtexchange at non-market prices, which raises the

question how a high participation rate can beachieved. The member states of the euro area andthe European institutions have several tools athand to promote this outcome. First, there arecurrently €32 billion in bilateral loans outstandingwhich have been provided to Greece by themember states of the euro area under the Inter-Creditor Agreement of May 2010. These medium-term loans are relatively expensive for Greece.They rank on equal terms with market debt andshould therefore also be exchanged into new

long-term Par or Discount bonds at a lowerinterest rate. Second, the ECB has purchasedaround €50 billion face of Greek governmentbonds through the Securities Market Programme.These holdings should be exchanged into newPar and Discount bonds as well. Third, Greekcommercial banks have currently pledged around €130 billion of bonds in refinancing transactionswith the ECB. The great majority of these assetsare government bonds. The ECB could decide toaccept only new Greek Par and Discount bonds as

eligible collateral in refinancing operations, whichwould provide commercial banks with a verystrong incentive to voluntarily exchange theirholdings of Greek government bonds into newobligations. In sum, this should already ensure aparticipation rate of close to 60%. Furthermore,the Greek government could reserve the option ofunilaterally changing the terms of all non-tendered bonds, as described in the followingsection of this paper, without awarding GDPwarrants to their holders. This should furthermotivate existing investors to exchange theirbonds into new obligations. Finally, there is the

change in relative liquidity after completion ofthe exchange: “hold-out” creditors would findthat existing Greek government bonds havebecome extremely illiquid, while new Greekbonds would have much higher market liquidity.This is another incentive to agree on a voluntaryexchange.

In sum, a voluntary exchange as described aboveshould be able to achieve a participation rate inexcess of 90%. In a legal sense, a voluntaryexchange that is not ex ante binding to all holderswill likely not constitute a credit event under theterms of ISDA master agreements, and should nottrigger sovereign CDS contracts. As a result,investors who have bought protection on Greecein the market for credit derivatives would not beable to benefit from this form of mutually-agreed

debt reduction. Such an orderly and controlledapproach would allow the Greek government tosignificantly reduce its interest burden whileavoiding threats to financial stability that may beassociated with a unilateral debt restructuring.Most importantly, restoring financial stabilitywould allow the Greek private sector to get backto business and to put the physical and humanendowment of the country to productive use.

8. Unilateral debt restructurings

are possible, but not desirableA number of observers have categorically deniedthat it could be in the interest of the governmentof an advanced economy to restructure itsgovernment debt. If that were the case, therewould be no need to derive orderly approaches todebt reduction. However, such arguments caneasily be refuted.

Cottarelli et al. (2010) argue that governments inthe periphery of the euro area are currently

running large primary deficits. These governmentdeficits before interest payments need to beeliminated through fiscal tightening in any case.If a government running a primary deficit decidesto default on its debt, it will be shut out fromborrowing and will have to cover all non-interestexpenditures through primary revenues. Thus, itmakes no sense for governments with primarydeficits to default. Cottarelli et al. go on to arguethat it would also be irrational for thesegovernments to restructure their debt once they

have achieved primary balance, as “the neededadjustment in today’s advanced economieswould not be much affected by debt




restructuring, even with a sizable haircut”. Theyillustrate this point with a numerical example onGreece’s public debt. Based on the numberspresented by Cottarelli et al., Greece would run aprimary balance (p) of -8.6% of GDP in 2010.Public debt (d) is projected to reach around 148%of GDP between 2011 and 2015 and we have seenin section 7 of this paper that it carries an averagenominal interest rate (r) of around 4.3%. Cottarelliet al. implicitly assume nominal trend growth (g )of 0.5% in the coming years to derive an interest-growth differential (r-g ) of 3.8%. It can be shownthat the debt-stabilizing primary balance (p*) isdefined as the interest-growth differential,multiplied by the stock of debt (Blanchard, 1990)– in short, p* = d(r-g).

Based on the parameters chosen by Cottarelli et

al., this would mean that Greece has to achieve aprimary surplus of 5.6% of GDP to stabilize itspublic debt. Therefore, Greece would be requiredto move from a 2010 primary deficit of 8.6% ofGDP to a primary surplus of 5.6% of GDP – atotal adjustment of 14.2% of GDP, which is quiteunprecedented. Cottarelli et al. then argue that adebt restructuring with a ‘haircut’ of 50% wouldonly reduce the debt-stabilizing primary surplusto 2.7% of GDP, which would still leave Greecewith a cumulative fiscal adjustment need of 11.3%

of GDP. The authors conclude that it would beirrational for a country such as Greece to restruc-ture its public debt once it has gone through thepain of reducing its primary deficit to zero, as itwould already have completed close to 80% ofthe needed adjustment to restore sustainability.

Cottarelli et al. have mis-specified the parametersof their calculations: IMF staff expects Greece toreach a primary deficit of 2.4%, not 8.6% in 2010,and it is implausible to assume an interest-growth

differential of 3.8% at the outset. Furthermore,their argument against debt restructuring is basedon a fallacy: the authors assume that the interestrate that Greece would have to pay on its publicdebt is independent of the level of debt. This isclearly wrong: governments with a high debtburden run a greater risk of defaulting on theirdebt and therefore have to pay higher riskpremia. After a ‘haircut’ of 50%, Greece’s publicdebt would fall from 148% to 74% of GDPaccording to the calculations of Cottarelli et al.,

and this would command a much lower interestrate. It has already been shown in Reinhart et al.(2003) that

the interest rate a country must pay on its debt isan endogenous variable [in debt sustainabilityanalysis], which depends, among other things, onthe country’s debt-to-output (or debt-to-exports)ratio. Because the interest rate on debt to privatecreditors can rise very sharply with the level ofdebt, ... a trajectory that may seem marginally

sustainable according to standard calculationsmay in fact be much more problematic.

Furthermore, it can be shown empirically thatlower levels of public debt go hand in hand withhigher trend growth. In sum, lowering the levelof public debt changes debt dynamics both byaffecting the average interest rate (r) on the debtand the growth rate of the economy (g ). Insteadof facing an interest-growth differential of 3.8% atan elevated level of public debt, Greece could facean average nominal interest rate of 4% after a

successful debt exchange, and a nominal trendgrowth rate of 3%. This would reduce the debt-stabilizing primary surplus to around 1% of GDP,significantly below the 2.7% level suggested by asimplistic calculation. More importantly, keepingGreece’s public debt level at 148% and its publicdebt service above 6% of GDP would almostcertainly make it impossible for the country tofund itself in the market going forward.

Others have argued that sovereign debt

restructuring would be too costly for advancedeconomies. While a breach of contract certainlycarries economic costs because of damages toproperty rights and to the rule of law, it can beshown that most of the associated loss in outputoccurs anyway in a sovereign debt crisis, whetherthe sovereign ends up validating investorconcerns by defaulting on its debt or not (Yeyatiand Panizza, 2011).

In sum, there may be situations in which abenevolent government should choose to

restructure its sovereign debt, as suggested by thesimple model in Calvo (1988).

It has been argued by Gianviti et al. (2010) andothers that it would be difficult for euro areasovereigns to undertake a unilateral debtrestructuring because they would not know howto deal with the problem of non-consentingcreditors. This is actually not the case. Euro areagovernments do not need elaborate “SovereignDebt Restructuring Mechanisms” (SDRM) or

“Collective Action Clauses” (CAC) to achievevery high participation rates in unilateral debtrestructurings.




Past sovereign debt restructuring exercises in‘emerging markets’ have suffered from free-riding problems, as non-consenting creditorsended up being paid in full, at the expense ofcooperative lenders. This was due to the fact thatemerging markets’ sovereign debt has typicallybeen issued under New York or English law,which made it impossible to render changes inthe payment terms legally binding for allcreditors. It was a minor problem, however.Based on a thorough review of past debtrestructuring exercises, Panizza et al. (2009)conclude that proposals for an SDRM “canperhaps be criticized (with the benefit ofhindsight) for having barked up the wrong tree –creditor coordination failures did not, in the end,turn out to be a significant impediment to thedebt renegotiations of the 1998-2005 period.” Inthe European context, there is even less of a needfor an SDRM, as almost all public debt has been

issued under domestic law. 95% of all bondedGreek public debt is governed by Greek law andprovides no contractual negotiation rights tocreditors at all, as Box 1 shows. These instrumentscan be restructured unilaterally, as suggested byBuchheit and Gulati (2010), and there is nothingbondholders can do about it.

We conclude that it would be both feasible anddesirable for highly indebted euro areagovernments to restructure their sovereign debtunilaterally, if they fail to regain market accessafter several years. This would likely haveunwelcome consequences for financial stability inthe euro area. Such an outcome should beavoided through a creative and cooperativesolution such as the debt exchange proposaldeveloped in this paper.

Box 1: Legal provisions on Greek domestic debt, compared to a typical Emerging Markets sovereign bond

Negative Pledge

Hungary: “The Republic undertakes that, if it or the National Bank of Hungary creates or permits to subsist anySecurity Interest upon … their assets or revenues, present or future, … the Republic shall, at the timeor prior thereto, secure equally and rateably therewith the obligations of the Republic under theNotes.”

Greece: “Negative Pledge: None.”

Consequence: Greece can pledge any state income to third parties, such as airport taxes or lottery income, and theseincome streams would not be available to holders of sovereign debt in the event of a restructuring.

Cross default

Hungary: “If any of the following events occurs and is continuing: … (ii) Breach of other obligations: theRepublic defaults in the performance or observance of any of its other obligations … then … all of theNotes may … be declared immediately due and payable.”

Greece: “Cross Default: None”

Consequence: Greece can undertake a selective default without triggering a restructuring of its stock of public debt.

Governing Law

Hungary: “The Notes are governed by, and shall be construed in accordance with, English law. The Republicagrees for the benefit of the Note holders that the courts of England shall have jurisdiction to hear and

determine any suit, action or proceedings, and to settle any dispute or difference arising out of or inconnection with the Notes … The Republic irrevocably waives any objection which it might now orhereafter have to the courts of England being nominated as the forum to hear and determine anyProceedings and to settle any Disputes, and agrees not to claim that any such court is not aconvenient or appropriate forum.”

Greece: “Governing Law: Greek law.”

Consequence: Greece can dictate the conditions of a sovereign debt restructuring, and creditors will not be able tolitigate in foreign courts or to freeze Greek assets abroad.

Note: Excerpts from the prospectuses of Hungary 5.75% government bonds due 2018, issued in 2008(ISIN XS0369470397) and Greece 5.30% government bonds due 2026, issued in 2009 (ISIN GR0133004177).




ReferencesAllen, Mark, Christopher Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini (2002), A Balance

Sheet Approach to Financial Crisis, IMF working papers, No. 210, Washington, DC: InternationalMonetary Fund (http://www.imf.org/external/pubs/cat/longres.cfm?sk=16167.0).

Alphandéry, Edmond (2010), “Pour une agence européenne de la dette”, Le Figaro, 11 February 2010.

Bini Smaghi, Lorenzo (2010), “The Challenges Facing the Euro Area”, speech given at the OMFIF meetingin Abu Dhabi, 1 November 2010 (http://www.ecb.int/press/key/date/2010/html/sp101101.en.html).

Bernoth, Kerstin, Jürgen von Hagen and Ludger Schuknecht (2006), Sovereign Risk Premiums in theEuropean Government Bond Market, Working Paper (http://www.iub.edu/~econdept/conference/vonHagenpaper.pdf).

Blanchard, Olivier (1990), Suggestions for a new set of fiscal indicators, OECD Working Paper, No. 79, Paris:Organisation for Economic Cooperation and Development.

Buchheit, Lee, and Gaurang Mitu Gulati (2010), How to Restructure Greek Debt, published on the SocialScience Research Network (http://ssrn.com/abstract=1603304).

Bulow, Jeremy, and Kenneth Rogoff (1988), “The Buyback Boondoggle”, Brookings Papers on Economic

Activity, No. 2, pp. 675-698.

Bundesbank (2011), “Zur Diskussion um Sekundärmarktkäufe des künftigen EuropäischenStabilitätsmechanismus”, Monatsbericht, February, pp. 72-73, Frankfurt: Deutsche Bundesbank(http://www.bundesbank.de/download/volkswirtschaft/monatsberichte/2011/201102mb_bbk.pdf).

Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review,Vol. 78, No. 4, pp. 647-661.

Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2003), Sudden Stops, the Real Exchange Rate, andFiscal Sustainability. Argentina's Lessons, NBER Working Paper, No. 9828, Cambridge, Mass.:National Bureau of Economic Research.

Chemical Bank (1992), “Final agreement on transactions to be offered to the commercial bank creditors ofthe Philippines”, press release, New York, 20 February 1992.

Cohen, Daniel (2010), “La Grèce est-elle solvable?”, Lettre PSE, No. 2, June 2010, p. 1(http://www.parisschoolofeconomics.eu/IMG/pdf/N2-juin2010-LettrePSE.pdf).

Cottarelli, Carlo, Lorenzo Forni, Jan Gottschalk, and Paolo Mauro (2010), Default in Today’s AdvancedEconomies: Unnecessary, Undesirable, and Unlikely, IMF Staff Position Note, No. 10/12, Washington,DC: International Monetary Fund (http://www.imf.org/external/pubs/ft/spn/2010/spn1012.pdf).

De Grauwe, Paul, and Wim Moesen (2009), “Gains for All. A Proposal for a Common Euro Bond”,Intereconomics, Vol. 44, No. 3, pp. 132-135 (http://www.intereconomics.eu/downloads/

getfile.php?id=680).Delpla, Jacques, and Jakob von Weizsäcker (2010), The Blue Bond Proposal, Bruegel Policy Brief, No. 3,

Brussels: Bruegel (http://www.bruegel.org/publications/show/publication/the-blue-bond-proposal.html).

DeLong, Bradford, Andrei Shleifer, Larry Summers and Robert Waldmann (1990), “Noise Trader Risk inFinancial Markets”, Journal of Political Economy, Vol. 98, No. 4, pp. 703-738.

Dornbusch, Rüdiger (1988), “Comment on The Buyback Boondoggle”, Brookings Papers on Economic Activity, No. 2, pp. 699-703.

Eichengreen, Barry, and Ashoka Mody (1998), What Explains Changing Spreads on EM Debt: Fundamentalsor Market Sentiment?, NBER Working Paper, No. 6408, Cambridge, Mass.: National Bureau of

Economic Research.




Eichengreen, Barry, Ricardo Hausmann and Ugo Panizza (2005), “The Pain of Original Sin”, in: BarryEichengreen and Ricardo Hausmann (ed.): Other People’s Money. Debt Denomination and FinancialInstability in Emerging Market Economies, Chicago: University of Chicago Press.

EU (1985), Council Directive of 20 December 1985 on the coordination of laws, regulations andadministrative provisions relating to undertakings for collective investment in transferablesecurities, Official Journal, L 375 (http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=

CONSLEG:1985L0611:20050413:EN:PDF).EU (2006), Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating

to the taking up and pursuit of the business of credit institutions, Official Journal, L 177 (http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:177:0001:0200:EN:PDF).

EU (2009), “EU steps in with emergency financing for three member states”, European Economy News, No.14, July 2009 (http://ec.europa.eu/economy_finance/een/014/article_8884_en.htm).

Fontana, Alessandro and Martin Scheicher (2010), An analysis of euro area sovereign CDS and theirrelationship with government bonds, ECB Working Paper No. 1271, Frankfurt: European Central Bank(http://www.ecb.int/pub/pdf/scpwps/ecbwp1271.pdf).

Gianviti, François, Anne Krueger, Jean Pisani-Ferry, André Sapir and Jürgen von Hagen (2010), A

European Mechanism for Sovereign Debt Crisis Resolution, 9 November 2010, Brussels: Bruegel.Goldstein, Morris, and Philip Turner (2004), Controlling Currency Mismatches in Emerging Markets,

Washington, DC: Institute for International Economics.

Guinnan, Timothy (2004), Financial Vergangenheitsbewältigung. The 1953 London Debt Agreement, YaleUniversity Economic Growth Center Discussion Paper, No. 880, January 2004 (http://www.econ.yale.edu/growth_pdf/cdp880.pdf).

Gros, Daniel (2010), “The Seniority Conumdrum. Bail out countries but bail in private, short-termcreditors?”, CEPS Commentary, 6 December 2010, Brussels: Centre for European Policy Studies.

Gros, Daniel and Thomas Mayer (2010), Towards a Euro(pean) Monetary Fund, CEPS Policy Brief, No. 202,Brussels: Centre for European Policy Studies (http://www.ceps.eu/book/towards-european-

monetary-fund).Gros, Daniel and Thomas Mayer (2011), Debt reduction without default?, CEPS Policy Brief, No. 233,

Brussels: Centre for European Policy Studies (www.ceps.eu/book/debt-reduction-without-default).

Haufler, Andreas, Bernd Lucke, Monika Merz and Wolfram Richter (2011), “The Plenum of GermanEconomists on the European Debt Crisis”, published on VoxEU.org, 24 February 2011(http://www.voxeu.org/index.php?q=node/6153).

Hausmann, Ricardo and Michael Gavin (1996), Securing Stability and Growth in a Shock Prone Region: ThePolicy Challenge for Latin America, IDB Working Paper, No. 315, Washington, DC: Inter-AmericanDevelopment Bank.

IMF (2010a), Global Financial Stability Report, April 2010, Washington DC: International Monetary Fund

(http://www.imf.org/external/pubs/ft/gfsr/2010/01/pdf/text.pdf).IMF (2010b), Global Financial Stability Report, October 2010, Washington DC: International Monetary Fund

(http://www.imf.org/external/pubs/ft/gfsr/2010/02/pdf/text.pdf).

IMF (2010c), Fiscal Monitor , November 2010, Washington DC: International Monetary Fund(http://www.imf.org/external/pubs/ft/fm/2010/fm1002.pdf).

Jeanne, Olivier and Jeromin Zettelmeyer (2006), “International Bailouts, Moral Hazard, andConditionality”, in: Ashoka Mody and Alessandro Rebucci (ed.): IMF-Supported Programs – RecentStaff Research, Washington, D.C.: International Monetary Fund.

Juncker, Jean-Claude and Giulio Tremonti (2010), “E-bonds would end the crisis”, Financial Times, 5December 2010 (http://www.ft.com/cms/s/0/540d41c2-009f-11e0-aa29-00144feab49a.html).

Krugman, Paul (1988), Market-based Debt-reduction Schemes, NBER Working Paper, No. 2587, Cambridge,Mass.: National Bureau of Economic Research.




Morris, Stephen and Hyun Song Shin (2006): “Catalytic finance: When does it work?”, Journal ofInternational Economics, Vol. 70, No. 1, pp. 161-177.

Ophranides, Athanasios (2010), “Strengthening economic governance in the euro area”, Remarks at theGoethe-Universität conference on Macroeconomic modelling and policy analysis after the globalfinancial crisis, Frankfurt, 15 December 2010, (http://www.centralbank.gov.cy/nqcontent.cfm?a_id=7842&lang=en).

Pagano, Marco and Ernst-Ludwig von Thadden (2004), The European Bond Markets Under EMU , CEPRDiscussion Paper, No. 4779, London: Centre for Economic Policy Research.

Panizza, Ugo, Federico Sturzenegger and Jeromin Zettelmeyer (2009), “The Economics and Law ofSovereign Debt and Default”, Journal of Economic Literature, Vol. 47, No. 3, pp. 653–700.

Reinhart, Carmen, Kenneth Rogoff and Miguel Savastano (2003), “Debt Intolerance”, Brookings Papers onEconomic Activity, No. 1, pp. 1-74.

Reinhard, Carmen, and Kenneth Rogoff (2009), This Time is Different. Eight Centuries of Financial Folly,Princeton: Princeton University Press.

Remolona, Eli, Michela Scatigna and Eliza Wu (2008), “The Dynamic Pricing of Sovereign Risk inEmerging Markets: Fundamentals and Risk Aversion”, Journal of Fixed Income, Vol. 17, No. 4, pp. 57-

71.Roubini, Nouriel and Brad Setser (2004), Bailouts or Bail-Ins? Responding to Financial Crisis in Emerging

Economies, Washington, DC: Institute for International Economics.

Schnabel, Isabel (2004), “The German Twin Crisis of 1931”, Journal of Economic History, Vol. 64, No. 3, pp822-871.

Schwartsman, Alexandre (2002), “J’Accuse”, Folha de São Paulo, 20 October 2002.

Standard Chartered (2011), Macro Strategy Views, 26 January 2011, London: Standard Chartered Bank(https://research.standardchartered.com/ResearchDocuments/Pages/ResearchArticle.aspx?R=75043).

Weber, Axel (2010), “Kaufprogramm birgt erhebliche Risiken”, Börsen-Zeitung, 11 May 2010.

Weber, Axel (2011), “Europe’s reforms may come at a high price”, Financial Times, 21 February 2011,(http://www.ft.com/cms/s/0/69f9bbd6-3df9-11e0-99ac-00144feabdc0.html).

Yeyati, Eduardo Levy, and Ugo Panizza (2011), “The elusive costs of sovereign defaults”, Journal ofDevelopment Economics, Vol. 94, No. 1, pp. 95-105.



ABOUT CEPS

Founded in Brussels in 1983, the Centre for European Policy Studies (CEPS) is widely recognised asthe most experienced and authoritative think tank operating in the European Union today. CEPSacts as a leading forum for debate on EU affairs, distinguished by its strong in-house researchcapacity, complemented by an extensive network of partner institutes throughout the world.

Goals• Carry out state-of-the-art policy research leading to innovative solutions to the challenges

facing Europe today,

• Maintain the highest standards of academic excellence and unqualified independence

• Act as a forum for discussion among all stakeholders in the European policy process, and

• Provide a regular flow of authoritative publications offering policy analysis andrecommendations,

Assets• Multidisciplinary, multinational & multicultural research team of knowledgeable analysts,

• Participation in several research networks, comprising other highly reputable researchinstitutes from throughout Europe, to complement and consolidate CEPS’ research expertiseand to extend its outreach,

• An extensive membership base of some 132 Corporate Members and 118 InstitutionalMembers, which provide expertise and practical experience and act as a sounding board forthe feasibility of CEPS policy proposals.

Programme Structure

In-house Research Programmes

Economic and Social Welfare PoliciesFinancial Institutions and Markets

Energy and Climate ChangeEU Foreign, Security and Neighbourhood Policy

Justice and Home AffairsPolitics and Institutions

Regulatory Affairs

Agricultural and Rural Policy

Independent Research Institutes managed by CEPS

European Capital Markets Institute (ECMI)European Credit Research Institute (ECRI)

Research Networks organised by CEPS

European Climate Platform (ECP)European Network for Better Regulation (ENBR)

European Network of Economic PolicyResearch Institutes (ENEPRI)

European Policy Institutes Network (EPIN)

Policy Brief No 237 Kopf on Restoring Financial Stability Rev

Documents

Transcript of Policy Brief No 237 Kopf on Restoring Financial Stability Rev