Benoît Coeuré: The euro area sovereign debt market: lessons from the
crisis
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank,
at the 12th IMF Annual Forum on Managing Sovereign Risk and Public Debt: "Managing
Sovereign Debt: A Seismic Shift in demand and Supply Dynamics?", Rio de Janeiro,
28-29 June 2012.
* * *
I wish to thank Maximilian Freier and Wolfgang Lemke for their contribution to this speech. I remain solely
responsible for the opinions contained herein.
Mr Deputy Managing Director, Ladies and Gentlemen,
It is a great pleasure to speak to you here today at the 12th IMF Forum on Managing
Sovereign Risk and Public Debt. Clearly, this topic has never been more relevant than today.
In my remarks today, I will focus on the experience in the euro area and consider the
following three questions: First, what has characterised the pricing of sovereign credit risk
over the last two decades? Second, what is the relevance of the sovereign debt market
tensions for monetary policy? And third, what lessons have we learnt?
What has characterised the pricing of sovereign credit risk over the last two decades?
Let me start with the first question, the pricing of sovereign risk. Looking at the sovereign
debt markets of the euro area over the past two decades, it is possible to clearly distinguish
three main periods. They all display distinct patterns of government bond pricing.1
First, there was the run-up to Economic and Monetary Union (EMU), that is especially the
period of about five years before 1999, when the euro was introduced. During this time,
sovereign bond yields quickly converged towards those of German Bunds. Much of this
convergence is explained by the elimination of exchange rate and inflation risks. In addition,
European governments made great efforts to reduce their deficit and debt levels in order to
fulfil the Maastricht criteria and join the common currency.
In the second period, ranging from the introduction of the euro in 1999 to the collapse of
Lehman Brothers in September 2008, government bond yields remained at moderate levels
and did not differ much from country to country. The yield spreads of ten-year government
bond yields vis-à-vis German Bunds reached a maximum of about 70 basis points, and
recorded about 15 basis points on average.2
These observations raise some questions: why did this period see such an undifferentiated
pricing of government debt securities? And were the "macroeconomic fundamentals"
characterising the different sovereign issuers similar? In fact, no: the state of public finances
was distinctly and persistently different across countries. So why was the different degree of
fiscal solidity (or rather the lack thereof) not "priced in" in government bond prices?
There are several reasons. Market participants may have been insufficiently forward-looking
and too complacent. They may have extrapolated from their experience of a long period of
low macroeconomic volatility - the so-called "great moderation" - and may have felt
insulated from any extreme macroeconomic event. In particular, it may have appeared
inconceivable that any euro area sovereign issuer could actually reach its "fiscal limit" - that
is, a situation where it could not re-finance its debt. Moreover, the "great moderation"
experience led to low levels of investors' risk aversion and low price of risk across asset
classes. The depth of euro-denominated government bond markets, together with the
expansion and diversification of global foreign exchange reserves, may also have created
the false perception that the demand for sovereign bonds was infinitely elastic. Finally, the
no-bail-out clause of the Maastricht Treaty may simply not have been fully credible for
investors.
In the third phase, since autumn 2008, a sudden and disruptive re-pricing of sovereign credit
risk has taken place. Government bond yields started to diverge, sometimes reaching levels
that matched and exceeded those of the early 1990s. There were fundamental reasons for
such a re-pricing of risk. Fiscal expansion due to the need to fight the crisis came on top of
already high levels of public debt. Governments' commitment to support systemically
important financial institutions added to their contingent liabilities. Lower potential growth
rates raised concerns for public finance sustainability.
In addition to these fundamental causes, sovereign bond markets in some jurisdictions have
been characterised by poor liquidity and high volatility. In this context, investors' worries
regarding a loss of market access for some Member States may have become entrenched,
and their expectations self-fulfilling. Moreover, for some countries, government debt market
liquidity has been threatened to completely dry up in some periods. Overall, there has been a
combination of fundamental causes and market distortions.
It soon became clear that the dramatic movements in government bond yields were not
merely a barometer of investors' valuation of liquidity and credit risk. Rather, the extreme
levels of bond yields themselves were exerting an adverse influence on other financial
market segments, the banking sector and also the effectiveness of monetary policy.
What is the relevance of sovereign debt market tensions for monetary policy?
There is a strong link between the stability of sovereign debt markets and the smooth
functioning of monetary policy. This becomes very clear once we consider the prominent role
of government bonds in the monetary policy transmission mechanism. I would like to identify
four channels through which the functioning of government bond markets can interfere with
the transmission of monetary policy. Let me call them the interest rate channel, the wealth
channel, the collateral channel, and the bank balance sheet channel.
First, government bonds play a key role in transmitting the monetary policy stance to the real
economy via the so-called interest rate channel. In times when government bonds are
considered as essentially risk-free and liquid instruments, a change in current and expected
policy rates is a central factor in shifting the government bond yield curve. Changes in
longterm bond yields, in turn, translate to some extent into movements in corporate bond yields
and bank lending rates - either via arbitrage relations or via pricing heuristics based on
government bonds -, thus ensuring a smooth transmission of monetary policy throughout
financial markets. However, since end-2008 bond yield changes of several sovereign issuers
in the euro area have become heavily dominated by high and volatile premiums, often driven
by contagion and market overreaction. Such effects have come to override changes in the
monetary policy stance, blurring the transmission of monetary policy signals to the real
economy.
Second, faced with threatening direct and indirect losses from strong price declines of
sovereign bonds, consumers may opt for precautionary savings, which would counteract a
desired stimulus to consumption from monetary policy easing.
Third, government debt securities have been a key source of collateral for banks to use in
secured lending with other banks and the ECB. With the sharp decline in sovereign bond
prices - often associated with a rating downgrade of the respective sovereign issuer -
government bonds were made subject to significant haircuts and their refinancing power
declined. This has eroded the volume of collateral available in the form of government bonds
and stressed the re-financing possibilities of banks.
Fourth, the re-pricing of government debt also had a direct negative impact on the asset side
of banks and therefore on their own perceived riskiness. In fact, since 2009, we can see a
close relationship between measures of bank and sovereign credit risk. This sovereign-bank
nexus constitutes a fundamental impediment to resolving the crisis in the euro area. On the
one hand, rising sovereign credit risk affects banks' credit risk via their exposure to
government debt. This creates deleveraging pressure that may turn into disorderly dynamics
characterised by fire sales. On the other hand, ailing banking sectors increase the burdens
faced by governments. These two effects are mutually reinforcing and constitute a vicious
circle. For the banks, the increase in their own credit risk makes their re-financing harder. In
short, unsecured financing is hampered by the perception of increased bank riskiness while
secured financing is undermined by the erosion of collateral. This can in turn become a major
obstacle to granting loans to the real economy. As banks are the main source of financing in
the euro area, this could seriously jeopardise the flow of credit to enterprises and
households.
What lessons have we learnt?
These developments in the euro area sovereign bonds markets offer one clear lesson:
financial markets are prone to exaggerations, which amplify further the pro-cyclicality
inherent in asset valuations. Usually, during "good times", when risk appetite is strong and
economic conditions are favourable, asset prices tend to be high and risk spreads tend to be
low. However, financial markets tend to be over-complacent from time to time, especially
after protracted periods that did not see any extreme events materialising. This tendency has
probably led to an excessive tightening of euro-denominated yields in the run-up to the euro.
In "bad times", when the degree of risk aversion increases and GDP growth contracts, asset
prices tend to decline and risk spreads rise. Also in bad times, this standard pattern of
procyclicality may be amplified by market exaggerations: investors tend to over-price certain
types of risk and thus under-price the respective financial assets. Exaggerated pro-cyclicality
of this type has hit the sovereign bond market during the crisis. Furthermore, in particular
through the use of sovereign bonds as collateral, it has exerted adverse effects on other
segments of financial markets, such as the funding markets for financial institutions.
To remedy exaggerated pro-cyclicality does not mean that we should dispense with the
disciplining role of financial markets. The history of the monetary union teaches us an
interesting lesson: when the disciplining role of intra-euro area exchange rates was lost,
volatility and tensions have in fact migrated to sovereign debt markets, where they were
building up under the surface. Even though markets sometimes misprice assets, they
nevertheless provide a useful service in terms of signalling, price discovery and incentives.
For example, if markets had not pushed up the yields of countries in weak fiscal positions,
imbalances would have remained unnoticed and grown much larger, and the cost of fixing
them would have been even higher. While attenuating exaggerated pro-cyclicality is
important to avoid self-fulfilling expectations leading to bad equilibriums, at the same time we
should recognise that markets have issued valuable signals.
There are a number of ways to mitigate exaggerated pro-cyclicality of government bond
markets. One way is to reduce the reliance of the financial, regulatory and supervisory
framework on credit ratings. The European Commission has put forward a number of
proposals to this end. Similarly, it is worth considering ways to delink the risk assessment of
credit institutions from the credit rating of the sovereign. In addition, risk management by
central clearing counterparties or CCPs is of particular importance, as an increasing number
of financial transactions is expected to migrate to them. The CPSS-IOSCO principles for
financial market infrastructures expect CCPs to adopt forward-looking and conservative
margin and haircut policies to limit the risk of destabilizing responses to changes in credit
ratings.
But to address the root causes of the current instability, fundamental policies will have to be
adopted.
The adverse feedback loop between banks and sovereigns, that I mentioned before, can be
broken by establishing a true financial union: in my view this includes the creation of a
pan-euro area deposit insurance fund and a pan-euro area bank resolution framework,
supported by a single supervisory system with centralised decision-making. If the European
Stability Mechanism - an institution that can provide financial assistance to euro area
Member States in order to safeguard the stability of the euro area as a whole - could inject
capital directly into banks, this would also help to break the bank-sovereign loop. Of course,
such support must come with strong conditionality and control. Let me note that depending
on its design, the financial union could introduce additional elements of risk-sharing among
euro area countries, and as such, it should be subject to strong democratic accountability
and control at national and European level.
Most importantly, all euro area countries need to return to sound macroeconomic and fiscal
positions. This may sound obvious, but unfortunately it has threatened to slip out of focus in
some of the recent discussions.
There has been substantial progress towards consolidating the foundations of EMU. Fiscal
rules are being strengthened, and almost all European governments have signed a Treaty
that contains the so-called fiscal compact, which mandates all contracting parties to
introduce legally enforceable debt brakes in their countries.3 The reformed governance
framework also provides new tools to improve budgetary surveillance as well as to prevent
and address macroeconomic imbalances - the "six-pack" reforms and the "two-pack"
legislation are examples and should be forcefully implemented.
Looking ahead, a path towards a fiscal union, based on a principle of responsibility and with
proper control and accountability, would provide a sound "fiscal pillar" on which the single
currency could safely rest.
Some have suggested that it could provide a basis for the introduction of euro area-wide
funding instruments with joint and several liabilities. Such instruments could contribute to a
smooth functioning of a stability-oriented monetary policy, protecting Member States from
temporary tensions arising in some parts of the Union and offsetting the emergence of
selffulfilling expectations leading to bad equilibriums. There is an important caveat, however. In
his 1790 Report on Public Credit, Alexander Hamilton wished "to see incorporated, as a
fundamental maxim in the system of public credit of the United States, that the creation of
debt should always be accompanied with the means of its extinguishment". Common funding
instruments would require shared decision making on national debts and deficits and
probably joint control on fiscal expenditures and taxation. They can only result from further
political integration; they cannot precede it.
Likewise, and importantly, a fiscal union can only come about once the participating
countries have successfully restored domestic fiscal sustainability and solidified the
conditions for long-term growth. Joint debt issuance cannot be a substitute for putting
national fiscal houses in order and restoring competitiveness.
Conclusion
Let me conclude. Euro area sovereign debt markets are going through unprecedented
challenges. The inherent pro-cyclicality and the exaggerations that at times characterize
financial markets should be recognized and addressed. However, structural problems call for
structural answers. The current overhaul of fiscal, financial and economic governance in the
euro area will help put the single currency on a sound and sustainable footing.