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Restoring financial stability in the euro area

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  • Kopf, Christian
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    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 currently preventing 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) permanent pooling of funding through joint bond issuance, ii) temporary liquidity assistance through multilateral funds, iii) debt buybacks using multilateral funds, and iv) debt restructuring. This Policy Brief by Christian Kopf, Director of Economic Research and Investment Strategy of the Spinnaker Capital Group, UK, attempts to evaluate these four proposals. He argues that joint bond issuance will not achieve a meaningful reduction of liquidity premia in the sovereign bond market; these instruments would either create perverse incentives or accelerate the sovereign debt crisis for peripheral Europe. An institution to provide temporary liquidity assistance is a necessary addition to the institutional framework of EMU – there needs to be an EMF to complement the ECB. Debt buybacks using multilateral funds can be a very useful tool for solvent countries such as Spain; they can prevent an overshooting of risk premia that could turn a sovereign liquidity crisis into a solvency crisis. However, a quantitative assessment shows that debt buybacks at market prices are insufficient to correct Greece’s debt overhang. In the case of Greece, a voluntary exchange of existing government 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 acceptable interest rates. In the absence of such an orderly and controlled public debt reduction, highly indebted euro area governments will likely opt to restructure their sovereign debt unilaterally, if they fail to regain market access 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.

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    File URL: http://www.ceps.eu/system/files/book/2011/03/Policy%20Brief%20No%20237%20Kopf%20on%20Restoring%20Financial%20Stability%20rev.pdf
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    Bibliographic Info

    Paper provided by Centre for European Policy Studies in its series CEPS Papers with number 4292.

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    Length: 26 pages
    Date of creation: Mar 2011
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    Handle: RePEc:eps:cepswp:4292

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    11. Schnabel, Isabel, 2002. "The German Twin Crisis of 1931," Sonderforschungsbereich 504 Publications 02-48, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
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    Cited by:
    1. Paul De Grauwe, 2012. "A Fragile Eurozone in Search of a Better Governance," The Economic and Social Review, Economic and Social Studies, vol. 43(1), pages 1–30.
    2. Fabian Lindner, 2013. "Banken treiben Eurokrise," IMK Report 82-2013, IMK at the Hans Boeckler Foundation, Macroeconomic Policy Institute.
    3. Paul De Grauwe, 2011. "Managing a Fragile Eurozone," CESifo Forum, Ifo Institute for Economic Research at the University of Munich, vol. 12(2), pages 40-45, 07.
    4. Büchel, Konstantin, 2013. "Do words matter? The impact of communication on the PIIGS' CDS and bond yield spreads during Europe's sovereign debt crisis," European Journal of Political Economy, Elsevier, vol. 32(C), pages 412-431.
    5. Keuschnigg, Christian, 2012. "Welche Finanz- und Wirtschaftspolitik braucht Europa?," Economics Working Paper Series 1201, University of St. Gallen, School of Economics and Political Science.
    6. De Grauwe, Paul & Ji, Yuemei, 2013. "Self-fulfilling crises in the Eurozone: An empirical test," Journal of International Money and Finance, Elsevier, vol. 34(C), pages 15-36.
    7. Schmid, Kai Daniel & Schmidt, Michael, 2012. "EMU, the changing role of public debt and the revival of sovereign credit risk perception," University of Tuebingen Working Papers in Economics and Finance 48, University of Tuebingen, Faculty of Economics and Social Sciences.
    8. Neményi, Judit & Oblath, Gábor, 2012. "Az euró bevezetésének újragondolása
      [Rethinking Hungary s prospective adoption of the Euro]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(6), pages 569-684.
    9. Gunther Tichy, 2012. "Zum Versagen der Marktdisziplinierung in der Finanzkrise," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, vol. 13, pages 58-80, 05.
    10. Gros, Daniel & Alcidi, Cinzia & Giovannini, Alessandro, 2012. "Central Banks in Times of Crisis: The FED vs. the ECB," CEPS Papers 7160, Centre for European Policy Studies.
    11. Valiante, Diego, 2011. "The Eurozone Debt Crisis: From its origins to a way forward," CEPS Papers 5985, Centre for European Policy Studies.
    12. Canale, Rosaria Rita, 2011. "Default risk and fiscal sustainability in PIIGS countries," MPRA Paper 32215, University Library of Munich, Germany.
    13. De Grauwe, Paul, 2011. "Governance of a Fragile Eurozone," CEPS Papers 5523, Centre for European Policy Studies.
    14. Gros, Daniel, 2012. "A simple model of multiple equilibria and sovereign default," CEPS Papers 7174, Centre for European Policy Studies.
    15. Martin Schütte & Nicholas Blanchard & Michael Hüther & Bernd Lucke, 2012. "Eurobonds: Kann eine Unterteilung in »Blue Bonds« und »Red Bonds« das Risiko für die Euroländer minimieren?," Ifo Schnelldienst, Ifo Institute for Economic Research at the University of Munich, vol. 65(04), pages 03-15, 02.
    16. Paul De Grauwe, 2011. "La gobernanza de una frágil Eurozona," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 13(25), pages 13-41, July-Dece.

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