How Europe should harness market forces to deal with sovereign credit risk

Mathias Hoffmann 20 March 2010

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The sovereign debt crisis has revealed the lack of a mechanism for an orderly unwinding of fiscal imbalances and default in the Eurozone. Markets expect that the big EMU countries will eventually have to bail out Greece to avoid contagion to other, bigger countries and to defuse systemic risk for their own banking sectors. There is wide agreement that such a mechanism is urgently needed. However, many economists, politicians and members of the public – notably in countries like Germany – show understandable reluctance to implement large, redistributive fiscal insurance schemes at the European level and are afraid of the precedent that a bailout would set.

Where do we go from here?

A recent proposal by Daniel Gros and Thomas Mayer (published in The Economist and on this site) is to create a European Monetary Fund (EMF). Similar to the IMF, the EMF could offer an orderly unwinding and would impose severe conditionality in case of an imminent sovereign bankruptcy of an EMU member – a Chapter 11 for EMU members. The proposal has since received backing from the German government (see Wolfgang Schäuble's article in the Financial Times).

But a problem remains: who is going to pay? Gros and Mayer suggest that funding for the EMF should be based on provisions analogous to the Stability and Growth Pact, with higher contributions being imposed on countries that have the highest deficits. However, such ex-post sanctions have not worked particularly well in the past. What would an alternative financing mechanism that exploits market forces and provides ex-ante incentives for fiscal discipline look like?

How the EMF should be funded

The future EMF should fund itself by implementing a European Sovereign Insurance Scheme. This scheme would sell bond insurance on EMU members' sovereign debt in the form of a European Sovereign Insurance Bond. In the good times the insurance fees would allow the EMF to build up a capital cushion. In times of crisis, the EMF could use these funds to do what it is supposed to do, i.e. facilitate an orderly unwinding of the default while imposing tough conditions on the government that calls it in.

The ground rules for the scheme would be as follows. First, member countries would not be allowed to buy insurance on their own debt, only private market participants would.

Second, there should be a clearly communicated limit up to which the EMF would be allowed to issue such insurance bonds. This limit could, for example, be set based on the Stability and Growth Pact's 60% rule. Hence, the fund would stand ready to sell insurance (in the form of European Sovereign Insurance Bonds) to the bearer of a member country's sovereign bonds but only to the extent that the fund's total insurance commitments for this country do not exceed 60% of the country's GDP. This would automatically limit supply of European Sovereign Insurance Bonds and provide a market mechanism for the pricing of default risk. The closer the funds insurance commitments for a specific member country get to the 60% limit, the higher the price of insurance would rise.

Currently many market participants expect to get this insurance for free. Instead, EMU countries should harness market forces and sell this insurance -- thus largely relieving the European taxpayer from having to take on obligations for individual countries with irresponsible fiscal policies. Greek bond spreads over the last decade reveal how much markets believed that such a bailout would happen if push came to shove. Spreads for German government bonds were almost nonexistent and only started to widen in the mayhem of the financial crisis. At the long end, spreads are still small.

The existence of a liquid market for European Sovereign Insurance Bonds would force each member country to bear the full cost of its borrowing from the outset. This would require countries like Greece to discipline their spending much earlier. The perception that all sovereign debt in the Eurozone is created equal was always flawed. The scheme proposed here would get rid of this perception altogether – and that would be for the better. Nobody would argue that recurrent fiscal crises of US federal states (such as currently in California) are endangering the dollar. While this argument is not new, it is worth considering how the US itself has responded to such fiscal crises in its history. For example, it was the refusal of the federal government to bail out New York City in the 1970s that led to the creation of privately organised markets for municipal bond insurance. The market for European Sovereign Insurance Bonds that I propose here is very similar to that, with the important difference that there is a central counter-party – the EMF.

But would the EMF's insurance offering be credible? As with all monetary and fiscal institutions, credibility is an issue and it is therefore an indispensable condition that the EMF (as the body running the European Sovereign Insurance Scheme) has a solidly independent status, similar to that of the European Central Bank. Only this would make sure that the fund does not increase the supply of sovereign insurance under political pressure. Such credibility will not be easy to acquire – but the ECB is proof that it can be done. After all, nothing could ultimately be less credible and more damaging to the whole of EMU than the current muddle.

The creation of a market-based European Sovereign Insurance Scheme would offer a huge advantage in communicating to markets how far economic solidarity in the Eurozone is progressing – and from that point on markets can only bet in vain on being bailed out. By standing ready to insure member countries debt up to a fixed limit, the EMF would create clearly defined tiers of entitlement on European Sovereign Insurance Scheme funds.

  • First, in case of default, the fund would stand ready to guarantee the nominal value of the country's insured debt from its pool of accumulated insurance fees.
  • Second, it would use scheme funds for keeping the distressed country afloat, imposing harsh conditionality while providing emergency lending. But the rules should explicitly forbid European Sovereign Insurance Scheme funds from being used to satisfy uninsured lenders.

Would markets buy this insurance?

Knowing the tiers of entitlement outlined above they probably would. After all, there is a big and growing market for sovereign credit default swaps (CDS) in existence now. For the buyer, bond insurance would do almost the same thing as a CDS does. But bond insurance is different from CDS in that the guarantee is linked to a particular bond, implying that naked trades of default risk become impossible. At the same time the European Sovereign Insurance Bonds market would preserve one of the biggest advantages of having credit derivatives such as a CDS – it gives us a market price for default risk.

The creation of the European Sovereign Insurance Bonds would also avoid many of the political problems associated with implementing sanctions in the Stability and Growth Pact. The procedures of the pact are slow, subject to political meddling, and the political sanctions for fiscal irresponsibility typically come – if at all – a long time after a country has exceeded its debt or deficit limits. If there was a market for sovereign bond insurance, international creditors would have the possibility to see exactly what the price is for insuring the debt they buy. The spread on a profligate country's debt would therefore reflect this price at the time of issuance. The country would have to bear the full cost of fiscal irresponsibility from the outset. This would force fiscal discipline much earlier than is currently the case and it would do so through a market-based mechanism.

Another potential “collateral benefit” of the European Sovereign Insurance Scheme is that it would help take power back from the rating agencies which have played an odious role in the crises of the last two decades. The European Sovereign Insurance Bond market would establish an important reference indicator for sovereign default risk, allowing it to act as an early-warning system, which will help diffuse risks as they build up.

Conclusion: Not all sovereign debt is created is equal

The establishment of a European Sovereign Insurance Scheme along with an EMF would make clear to markets that not all sovereign debt in the Eurozone is created equal – and that it does not have to be for a monetary union to work. It would provide a market based mechanism that forces member countries the bear the cost of fiscal profligacy without having to leave EMU, and a mechanism that provides fiscal insurance on the margin without forcing the cost onto the European taxpayer.

In a situation where ever deeper political union in Europe is a vision that appears ever more distant, a European Sovereign Insurance Scheme would show that Europe's governments are able to act and willing to deal with the fiscal challenges that lie ahead.

References

Gros, Daniel and Thomas Mayer (2010), “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund”, VoxEU.org, 15 March.

Gros, Daniel and Thomas Mayer (2010), “Disciplinary measures”, The Economist, 18 February.

Schaube, Wolfgang (2010), “Why Europe’s monetary union faces its biggest crisis”, The Financial Times, 11 March.

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Topics:  Europe's nations and regions International finance

Tags:  EMU, sovereign debt, European Monetary Fund

Professor of International Trade and Finance at the Department of Economics, University of Zurich

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