Blog de Paul Jorion

Voici le texte de mon intervention au Parlement européen, Comité pour les affaires économiques et monétaires, le mardi 5 novembre 2013, de 15h30 à 18h30. Une plus longue version en français a déjà été publiée en deux parties, ici et là.

The future of the Eurozone can be approached as a logical problem. If not solved, it can at least be significantly clarified when the issue is examined from the single standpoint of the sovereign debt’s coupon for the nations belonging to the zone.

Within the economic zone where a currency applies, a single coupon level only should be in existence for each obligatory maturity. The founding fathers of the Eurozone assumed no doubt that such would be the case also for the zone – or at least would tend to become so on the long run. They did not envisage that measurable default risk would develop for individual member nations of the zone, neither of course that reverting to the old currency would ever be considered an option. The fact that for a single maturity coupons vary according to country within the Eurozone is as such an alarming symptom of its current troubles.

Components of a sovereign debt’s coupon

As far as the Eurozone is concerned, three components of an interest rate need to be considered, reflecting not only the economic but also the political circumstances of individual nations within the zone:

1. the liquidity premium
2. the credit premium
3. the convertibility premium

When I will be mentioning below the coupon associated with sovereign debt of a particular maturity, I will be referring to an interest rate composed of these three elements even if the credit premium and the convertibility premium have in one particular instance zero value.

1. The liquidity premium is the part of the interest rate reflecting the fact that a debt instrument is not money proper but a commodity which will convert into money proper at some scheduled time in the future. The liquidity premium is the price, expressed as an interest rate, for such deferment.

The liquidity premium for a particular maturity in a particular currency is determined by the power balance between would-be lenders and would-be borrowers for such a financial product on the capital markets. Supply and demand is one of the factors in that power balance as it exacerbates competition, either between potential lenders if credit supply exceeds demand or between potential borrowers if credit supply is lower than demand.

Typically, the liquidity premium differs between currencies, reflecting the circumstances of the economic zone where each applies. Such discrepancies open up arbitrage opportunities of a particular type, called carry trade: monies can be borrowed in a currency where the liquidity premium is circumstantially low and invested in a currency where it is circumstantially high.

2. The credit premium is claimed by the lender as an insurance premium against the risk that the principal, the sum borrowed, may fail to be refunded or that the contractually promised interest may fail to be paid out; both are deemed “credit events”.

There is a specific market for credit premiums: the Credit-default Swaps (CDS) market where one can insure oneself against credit event risk, but also make directional bets (“naked” CDS positions).

3. The convertibility premium covers the risk that money advanced in one currency will be refunded in a different one most likely devalued as against the first one; through e.g. reverting to the drachma, punt, escudo, etc.

Sovereign debt’s coupon within the Eurozone

If the Eurozone is the most familiar case where sovereign debt of a single maturity labelled in one currency may be associated with more than one coupon, the principle remains true however that sovereign debt of one maturity labelled in one currency holds but one liquidity premium.

Within the Eurozone, the liquidity premium for any particular maturity can be worked out by examining the interest rates associated with the sovereign debt for the one country whereof the credit premium and convertibility premium have value zero. This country is Germany.

Capital markets consider that the risk Germany defaults on its debt is nil; no credit premium attaches therefore to the coupon of its obligations. Similarly, capital markets consider that there is no chance that Germany will wish to leave the Eurozone – it is regarded instead as the likely “last man standing” in case of a disintegration of the zone – and there is therefore no convertibility premium attached to Germany’s sovereign debt.

[In an article dated 27 September 2012 in the New York Review of Books, entitled “The Tragedy of the European Union and How to Resolve It”, George Soros suggested that Germany should leave the Eurozone. Should such scenario become an option taken in earnest by the capital markets, the coupons of German debt of various maturities would start encompassing a convertibility premium; that premium would however have negative value, lowering the interest rate of the overall coupon, as the euro of a Eurozone deprived of Germany would get devalued as against a revived Deutsche Mark].

As coupons for German sovereign debt can be regarded as benchmarking the liquidity premium component of any sovereign debt’s interest rate within the Eurozone, the so-called “spread” of the coupon for another national sovereign debt is the sum of the credit and the convertibility premiums.

As soon as the notion of a nation member of the Eurozone defaulting on its sovereign debt gained plausibility and in the absence of any firm commitment that such a nation would not then leave the zone, the price of its credit and convertibility premiums rose above zero. A centrifugal dynamics was hence initiated for that nation and, the likelihood of such an occurrence having been dismissed at the inception of the Eurozone, the risk of the zone disintegrating materialised.

Distrust about a nation’s ability at meeting its financial obligations (principal and interest) raises the price of the credit premium demanded on its sovereign debt. Doubts relative to solvency feed further doubts relative to expected solidarity from other Eurozone nations, in the absence of which that nation would be forced to quit the zone. The price of the convertibility premium gets then added to that of the credit premium within the coupon demanded by the capital markets for loans of various maturities, worsening the nation’s risk of insolvency, forcing the other nations within the zone to salvage it by guaranteeing its debt.

The “disastrous sovereign-banking nexus”

A perverse effect is attached to the logic of credit and convertibility premiums, about which Jens Weidmann, President of the Bundesbank, has drawn attention (“Stop encouraging banks to buy government debt”, Financial Times, September 30, 2013), calling it “the disastrous sovereign-banking nexus”, by which commercial banks will increasingly be fond of their own country’s sovereign debt when default and convertibility risk rise. The reason why is easily understood even if at first sight paradoxical: indeed for a domestic bank, both credit premium and convertibility premium on sovereign debt translate simply into profit margin:

–       credit premium: if the nation defaults, its commercial banks are likely to become insolvent due to the excess of national sovereign debt in their portfolio but they will be rescued either by being “bailed-in” or “bailed-out”;

–       convertibility premium: if the nation reverts to its old currency, its commercial banks will do so as well; the convertibility premium, being of no application in their case, will amount to profit.

Additionally, such perverse effect is encouraged by two regulatory provisions: firstly, unlike what applies to other exposure which is limited for banks to 25% of their eligible capital, banks are authorised to buy sovereign debt in unlimited amounts; secondly, when buying sovereign debt, banks need not set aside sizeable equity capital: capital requirements are either zero or extremely low.

As a central bank acts as a last resort lender for the nation’s commercial banks, there exists de facto a common destiny between a central bank and its domestic banks. With commercial banks accumulating in ever rising amounts sovereign debt, they get increasingly exposed to a possible depreciation of it. Such an entanglement creates the potentiality for a positive feedback triggering a downward spiral: as a worsening of the nation’s financial circumstances affects negatively the portfolio of its commercial banks, the spectre of their insolvency rises while their poor health raises the credit risk of the nation as a whole and boosts the credit premium demanded on its sovereign debt.

The Eurozone’s options

In a series of events starting in the winter of 2009, Greece, Ireland, Portugal, then Spain and Italy were financially hurt in quick succession, to such an extent that the sovereign debt of the first three nations needed to be severed from issuance on the capital markets, the price of the credit and convertibility premiums having reached in their case such levels that the nations concerned were no longer in a position to pay out the coupon which the market demanded. The community of spared nations within the Eurozone took over with the help of the International Monetary Fund.

As of my writing Ireland claims it will be in a position to access once again the capital markets by December 2013; only Greece and Portugal would then require further support, Cyprus being a borderline case.

The lingering question is that of the solvency of the Eurozone as a whole. With the possible occurrence of further accidents within the zone as have plagued it since late 2009, the question remains for the foreseeable future that of the capacity of solvent nations within the zone to support in a joint effort those nations having lost access to capital markets due to the excessive rise of the credit and convertibility premiums demanded by the capital markets on these nations’ sovereign debt.

The overall question of the Eurozone boils down nowadays as to whether or not the solidarity displayed by solvent nations within it ensures the solvency of the zone as a whole.

In the first instance, the most favourable one: that of current overall solvency of the Eurozone, the financial context will remain sound as long as a rise in the credit premium and/or convertibility premium for one further nation doesn’t tip it from the solvent nations’ side guaranteeing the insolvent ones to the side of the assisted nations, in which case the financial balance of the full Eurozone needs to be reassessed in the light of the new circumstances. Even in this instance, the most favourable which can be envisaged for the Eurozone as of now, its circumstances remain in essence unstable and frail.

The second instance is the unfavourable one where the Eurozone as a whole is actually currently insolvent: where despite their joint efforts, solvent countries have lost their ability at guaranteeing the distressed nations’ sovereign debt in the zone without automatically jeopardising their own individual solvency. In that case, the alternative is the following:

1)               recreating a reduced zone of overall solvency after the departure of the insolvent nations, the latter addressing their demise through default, restructuring their sovereign debt and reverting to their old currency which, getting devalued as against the euro to the level required for restoring financial health, will allow a new departure with a clean slate;

2)               planning a generalised default of the Eurozone, restructuring debt as a whole in a common effort through mutualisation within the zone, the euro getting devalued as against other currencies; this can only be achieved through concurrent instant federalism at the financial, fiscal and banking levels.

This second approach only solves once and for all the constituent instability and frailty of the Eurozone under its current structure and modus operandi.

     October 26, 2013