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Restoring financial stability in the euro area

  • Kopf, Christian
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    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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    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
    Date of revision:
    Handle: RePEc:eps:cepswp:4292
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    1. Paul R. Krugman, 1988. "Market-Based Debt-Reduction Schemes," NBER Working Papers 2587, National Bureau of Economic Research, Inc.
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    7. Mayer, Thomas & Gros, Daniel, 2011. "Debt reduction without default?," CEPS Papers 4150, Centre for European Policy Studies.
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    10. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973, March.
    11. Ricardo Hausmann & Michael Gavin, 1996. "Securing Stability and Growth in a Shock Prone Region: The Policy Challenge for Latin America," IDB Publications (Working Papers) 5919, Inter-American Development Bank.
    12. Jakob von Weizsäcker & Jacques Delpla, 2010. "The Blue Bond Proposal," Policy Briefs 403, Bruegel.
    13. Schnabel, Isabel, 2004. "The German Twin Crisis of 1931," The Journal of Economic History, Cambridge University Press, vol. 64(03), pages 822-871, September.
    14. Carlo Cottarelli & Paolo Mauro & Lorenzo Forni & Jan Gottschalk, 2010. "Default in Today's Advanced Economies; Unnecessary, Undesirable, and Unlikely," IMF Staff Position Notes 2010/12, International Monetary Fund.
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