A straightforward solution to stop contagion would be to appoint the ECB as a lender of last resort in the government bond markets (Wyplosz 2011a). By making it clear that it is fully committed to exert this function, the ECB would restore confidence in the markets. Different variants of this approach could be considered, such as an announcement that the ECB would buy unlimited amounts of sovereign bonds if a solvent country came under attack (De Grauwe 2011), or an arrangement whereby the ECB would offer a limited guarantee on existing public debt and full guarantee on future public debt (Wyplosz 2011b).
ECB versus EFSF support
The ECB’s top management and German policymakers have rejected these proposals because their implementation would blur the boundaries between the responsibilities of monetary and fiscal policy (Weidmann 2011). For this reason, Eurozone leaders decided in July 2011 to address contagion by allowing the European Financial Stability Facility (EFSF) to intervene in the secondary markets on the basis of an ECB analysis recognising the existence of exceptional financial-market circumstances and risks to financial stability.
This approach raises two important – and unresolved – problems.
- Firstly, the EFSF – whose size was set before the EZ crisis entered ‘phase 2’ where Italian and Spanish debt is under threat1 – is too small to play any meaningful role of lender of last resort.
- Secondly, the ways in which the EFSF can intervene in the bond markets remain unknown.
To address the funding problem, European officials are now considering different plans to leverage the EFSF.2
Would the leveraging schemes work? It is difficult to answer this question without knowing how the EFSF would operate as the Eurozone’s ultimate line of defence. This highlights the importance of developing a coherent framework for thinking about EFSF interventions.
Guaranteeing financing at predefined interest rates
My proposal is to set up a framework that builds on the following principles:
- The EFSF would fully commit to purchasing new debt issued by solvent EZ members as soon as market interest rates reach a predefined level.
In other words, when a solvent EZ member would not be able to finance itself below a pre-determined interest rates, the EFSF would intervene. To limit the scope of its interventions, the EFSF would provide its support to sovereign issuances of long-term debt, which tend to be problematic in periods of liquidity crises.
The idea here is that the yield on already-issued bonds does not affect a government’s solvency. The issue only arises when it comes time to issue new bonds to either roll over the stock of debt or cover new government borrowing. Focusing only on the new debt issues thus turns the EFSF’s job into a more manageable size – one linked to the flow of new and rollover debt rather than the stock of debt (see figures for Italy and Spain below).
- The predefined interest rates would be expressed in terms of spreads vis-à-vis the German government bonds.
Ideally, such rates would be set by an independent committee composed of impartial experts and senior EU officials, including from the ECB. A number of factors reflecting the fundamentals of each country, in particular its public-debt ratio, implicit debt obligations and primary surplus, would be taken into account in the determination of the spreads. The spreads should be high enough to limit the access to the EFSF financing, but they cannot be too high, since there has to be sustainability.
- If an EZ member ever faced financial sanctions due to non-compliance with the Stability and Growth Pact and National Reform Programme the access to the EFSF financing would be suspended until the imbalance is corrected.
This would avoid rewarding bad behaviour and would reduce the perceived benefits of exceeding deficit targets.
Benefits of the proposed framework
The adoption of the proposed framework would allow to:
- Stop contagion: the predefined interest rates would eliminate the threat of a self-fulfilling debt crisis.
Investors would know that the Eurozone countries could not be trapped in a cycle of loss of confidence and rising interest rates that could degenerate into a situation of insolvency. They would also realise that they might miss interesting investment opportunities by refraining from lending at interest rates below the ceiling set by the EFSF. These circumstances should stir the markets toward the good “low-rates/solvent” equilibrium and away from the bad “high-rates/insolvent” one.
Conceptually the situation can be compared to the crisis of the European Monetary System in July 1993. At the time many investors and observers believed the exchange rates would never move back to their central rates parities. At the end, however, the authorities’ commitment managed to stir the exchange rates towards their parities.
- Increase transparency: the EFSF interventions would be constrained by well-defined and transparent criteria.
This transparency would ensure that the same rules apply to all countries. It would also remove uncertainty about the authorities’ commitment to do whatever is needed to ensure the financial stability of the Eurozone.
- Mitigate moral hazard: the EFSF’s commitment to offer unconditional long-term financing to EZ members raises a problem of moral hazard.
This problem should not be overstated because the predefined interest rates would be relatively high (in the order of several hundred basis points). This would create incentives for euro countries to make fiscal and economic reforms to obtain better rates than the EFSF ones. From this perspective the proposed framework would complement the recently adopted package of six legislative proposals on economic governance, and reinforce the preventive and corrective arms of the Stability and Growth Pact.
Funding: How much would the scheme cost?
The required funding for the proposed scheme could be calculated as a fraction of the expected total gross financing requirements of the euro countries in 2012-2014. This fraction would depend on two key parameters:
- The specific risk characteristics of each country (Italy is more vulnerable to contagion than France); and
- The average level of spreads vis-à-vis Germany (the higher the spreads, the more markets will be willing to purchase sovereign debts at interest rates below the predefined ones).
To be credible, the Eurozone’s policymakers would have to be cautious when estimating these parameters.
The increase in the size of the EFSF should be large enough to convince markets that the EFSF can deliver on its commitments. This does not mean, however, that the EFSF funding should be boosted to astronomic figures.
By way of illustration, the amounts of long-term sovereign bonds expiring are:
- In 2012, €121 billion for Italy, and €46 billion for Spain;
- In 2013, €118 billion for Italy and €60 billion for Spain.
Assuming that the EFSF would have to finance 25% of these amounts, it would need to purchase €86 billion; if the share were 50%, the cost would be €173 billion. While not being trivial, these figures suggest that the often cited ‘multi-trillion’ figures are on the high side. The difference, of course, is that the multi-trillion euro figures are referring to the stock of debt, not the new issuances (rollover and fresh borrowing).
EFSF going to the ECB?
An alternative to increasing the size of the EFSF would be to allow the EFSF to refinance itself at the ECB (Gros 2011). This approach would be well-suited to supporting the proposed framework. Indeed, it is likely that markets would test the EFSF’s commitment to the predefined interest rates.
This means that the EFSF may be forced to purchase large amounts of new sovereign debt for some time. Unlimited access to the ECB would therefore be useful in the early stage of implementation of the framework. However, given that the EFSF would purchase bonds from countries that are solvent at current policies conditional on low rates prevailing, there should be a point where the EFSF interventions would convince more and more investors to buy newly issued bonds. Therefore, as market pressure subsides, the EFSF would be able to resell the bonds it purchased, make a profit and reduce its exposure to the ECB.
The Eurozone needs to backstop the EZ members who are solvent to halt the spread of contagion of the debt crisis; this requires a lender of last resort. Whilst the ECB would be the natural institution to play this role, the Eurozone’s policymakers have decided to appoint the EFSF to perform this function. Whilst the question of the size of the EFSF is largely debated, very little has been written so far on the modalities of the action of the EFSF as a lender of last resort.
This column argues that the EFSF could play this role by committing to purchase new sovereign long-term bonds of solvent countries when market interest rates reach a certain level. The commitment should be credible and unconditional for the predefined interest rates to be a successful circuit-breaker for contagion risks. This would require to increase the size of the EFSF, albeit not to astronomic figures, or to grant it access to refinancing by the ECB.
Author’s note: The author would like to thank António Borges de Assunção and Stijn Claessens for helpful comments on a first draft of this column. The views and opinions expressed herein are solely the author’s.
Baldwin, Richard (2011), “Welcome to phase 2 of the Eurozone (EZ) crisis”, VoxEU.org, 5 September.
De Grauwe, Paul (2011), “The European Central Bank as a lender of last resort”, VoxEU.org, 18 August 2011.
Gros, Daniel (2011), “August 2011: the euro crisis reaches the core”, VoxEU.org, 11 August 2011.
Münchau, Wolfgang (2011), “The latest Eurozone fix is a con trick for the despite”, Financial Times, 3 October 2011.
Weidmann, Jens (2011), “The crisis as a challenge for the Eurozone”, Speech at the Association of Family Enterprises, Cologne, 13 September 2011.
Wolf, Martin (2011), “Fear and loathing in the Eurozone”, Financial Times, 27 September 2011.
Wyplosz, Charles (2011a), “They still don’t get it”, VoxEU.org, 22 August.
Wyplosz, Charles (2011b), “A failsafe way to end the Eurozone crisis”, VoxEU.org, 26 September.
1 See Baldwin (2011).
2 See Münchau (2011) and Wolf (2011) for more on comments on these plans.
Editor's Note: The author, Bernard Delbeque, received an interesting comment from Paul De Grauwe in response to this column. Essentially De Grauwe suggested that the problem of the sovereign debt crisis is a stock problem and that during a crisis, holders of the bonds are distrustful and want to dispose of the bonds as quickly as possible. A solution whereby the EFSF buys only newly issued debt does not solve this problem. Direct purchases by the ECB need to be very costly, as it all depends on the degree of confidence the ECB can generate. If it makes it clear that it is fully committed to use all its firepower (which is in fact unlimited) to put a floor on the prices of government bonds, markets will be confident and stop selling. In that case the ECB may not have to buy many bonds. Today the ECB does not profit from this confidence effect because it has made it clear that it thoroughly dislikes buying bonds and will stop as soon as possible. This creates a lot of uncertainty, forcing the ECB to buy more than if it would take the ‘bazooka’ approach.
In response to this comment, the author clarified his proposal, which is included here in full as an addition to the column:
I agree that the ECB would give the EZ a bazooka that would stop the liquidity crisis for the reason you explain. As this approach is not (yet) accepted, I tried to propose an alternative approach founded on the EFSF's commitment to purchase new bonds issued by governments to refinance themselves. In my view this approach has three advantages:
1) The amount of bonds that the EFSF would have to buy over time would be limited to a fraction of the new issuances of sovereign bonds. This is an important point to highlight, that the resources needed to follow this approach would be limited.
2) There would be a cap on the interest rates level at which governments could refinance themselves: this would limit the rise of the average interest rate on the public debt of EZ countries.
3) In a situation where the EFSF's commitment is credible and unconditional, investors would know that, for example, Belgium would be able to sell 10-year government bonds at, say, 5.5% maximum. This level of interest rate would be attractive compared to German rates, and compared to short-term interest rate levels. This situation would create a dynamic in the market whereby investors will start buying the newly issued bonds at rates below the guaranteed EFSF rates, with some players borrowing at short-term rates to benefit from the higher-than-optimal long-term interest rates.
I therefore believe it is helpful to distinguish between the existing stock of public debt and the newly issued bonds. In the situation today, the rates on the secondary markets influence the rate on the new debts. In a situation where the EFSF would cap the rates on new sovereign bonds, the rates on the new debts will influence the rates on the secondary markets.
In my paper I also tried to go beyond the notion that the EFSF (or the ECB) should be mandated to become the EZ lender of last resort. In the papers I read before, including from you, this notion was not explained (except to say that these institutions should intervene in the secondary markets and/or guarantee new and/or existing public debt). To my knowledge, no one has previously proposed to define the lender of last resort function in terms of a commitment to defend a predefined level of interest rates.