Euro safe assets and debt restructuring in focus as elements of euro reform

Safe assets created by pooling sovereign debts of different risk characteristics are one of the ideas put forward in the discussion about reforming the euro zone. Another proposition is making debt restructuring credible. These ideas, as well many other proposals, were discussed in “Seminar on Safe Assets, Sovereign Debt and Financial Stability” (Bank of Finland Auditorium) on Monday 22.1.2018.

Opening by Vesa Vihriälä, Managing director, Research Institute of the Finnish Economy:

Financial assets which can be considered safe, that is, about whose value no questions need to be asked, play an important role in the financial system. They are a central source of liquidity, as they can either be used as a means of payment directly, converted into such liquid instruments with minimal costs, or readily used as good collateral for borrowing.

The most important category of safe assets is sovereign debt, short-term as well as long-term instruments. Their safety stems ultimately from the governments’ capacity to tax. But also from private, inherently risky assets a fraction can be transformed into safe assets through financial engineering. Likewise, government guarantees, explicit or implicit, can support the creation of safe assets from risky ones. Government can institute insurance mechanisms and provide backstops to enhance the safety of private assets, such as bank deposits covered by deposit insurance.

The returns on safe assets have been going down – also relative to those of risky assets – for two or three decades. The discrepancy accentuated at the start of the Great Recession and has not been reversed so far. This trend suggests that the demand for safe assets has increased relative to the supply. There can be several reasons for the increase in demand, including the evolution of saving and investment imbalances globally.

However, also the supply of safe assets appears to have declined. In part this may be because the financial system’s capacity to engineer safe assets from risky ones was impaired during the crisis. The crisis revealed many presumed low-risk synthetic instruments to be anything but low risk.

On the public sector side, the high debt levels have reduced the capacity of many governments to provide safe assets. This phenomenon, particularly true in the euro zone, has shown up in the emergence of high risk premiums on sovereign debt. For many sovereigns, the existing debt instruments, while still considered formally safe in the prudential regulation, have become less safe than before. This implies that a given nominal amount of such debt supports a smaller amount of borrowing as collateral.

The debt problems of several euro zone states have led to unprecedented policy actions. Financial assistance to distressed sovereigns from other member states and the creation of, first, temporary support arrangements and then a permanent stability mechanism, the ESM, helped to maintain market access and reduced financing costs of the affected states.

Similarly, the QE policy of the ECB has swapped massively assets with at least some credit risk for central bank liabilities, which undoubtedly can be considered safe. And at least as importantly, the OMT promise by the ECB, even if never activated, has contributed to increasing the safeness of existing sovereign bonds and reduced spreads. While the proximate aim of these policies has been to support financial stability, in doing so they have helped to maintain the supply of safe assets in the euro zone.

Despite these policy actions, the European sovereign debt crisis has shaken the assumption that all sovereign debts can be considered equally safe.  Greek debt was restructured.  The spreads of several other sovereigns’ debt vis-á-vis German bunds remained elevated for extended periods. Furthermore, the spreads have not disappeared even in the recent more tranquil times. All this is in clear contradiction with the idea of equal and low riskiness of various sovereign debt instruments.

Perhaps even more importantly, the idea has gained ground that the differences in the riskiness of sovereign debt are not only a symptom of crisis or a bad thing but rather a normal state of affairs, which should be acknowledged in the prudential regulation and – indeed – embraced. By embracing I mean the assumed or at least hoped-for market discipline on excessive government borrowing stemming from risk premiums.

The idea of market discipline is controversial, as we all know. It is based on the assumptions (1) that the risk premium on sovereign debt is a stable function of the prudence of a government’s fiscal management, (2) that it would not react erratically to spurious information, and (3) that an eventual failure of a sovereign to honour its debt commitments would not lead to major financial instability.

All these assumptions can be and have been challenged. There was no market discipline before the euro crisis despite the famous no-bailout clause in the Treaty on the Functioning of the European Union. One can also argue that there were excessive market reactions during the crisis, and question whether generalised financial instability in the euro zone can ever be avoided in the case of a default of a big member state.

On the other hand, first, there is no doubt that market pressures have contributed to necessary adjustments in many instances during the crisis. Second, the Greek debt restructuring could be managed without significant spill-over effects on other member states. And third, even outright defaults have not led to long-lasting exclusions from the debt markets, say, in South America.

Thus, it would not seem inconceivable that a system could be established to facilitate an orderly restructuring of sovereign debt in the euro area, and that such a system would create salutary incentives for the member states to avoid excessive indebtedness. Having accepted the bail-in principle that – as a rule – bank liabilities carry a default risk, accepting that also certain sovereign liability categories carry such a risk should not be impossible. However, even in the best circumstances the implementation of a well-functioning debt restructuring mechanism would be tricky and take considerable time. It might even require extraordinary one-off measures to reduce debts, given the current high debt levels of many member states.

Whatever the precise long-term vision is, it seems clear to me that there is no return to the years when euro area sovereign debts were considered equally low risk, equally safe. Thus we will face the tension between the benefits of safe assets on the one hand and the factual riskiness of individual sovereign bonds, on the other hand.

Today’s seminar organised jointly by the Research Institute of the Finnish Economy, Etla, and  Bank of Finland is intended to shed light to the various aspects of this tension and in particular on the ways to reconcile the need for safe assets with risky sovereign debts.

Bragging is not highly valued in this country. Nevertheless, I would argue that we have succeeded with the timing of our seminar. Germany is entering negotiations about a government programme in which the reform of the euro area institutions is likely to figure prominently. Last week, a group of German and French economists, one whom is here today, published a paper on euro area reform. Among other things, the paper included proposals about setting up a mechanism for restructuring sovereign debt and introducing synthetic euro area safe assets. An ESRB expert group, the chairman of which happens to be here with us today as well, will soon publish its report on euro safe assets.

Keynote speakers:

“Safe Assets in the Euro Area” by Philip R. Lane, Governor, Central Bank of Ireland Philip Lane (Slides)

“Restructuring sovereign debt – why and how to do it without endangering financial stability” by Jeromin Zettelmeyer, Peterson Institute of International Economics Zettelmeyer (Slides)

(from left) Olli Rehn, Sylvie Goulard, Jeromin Zettelmeyer and Philip Lane.