Sunday, 3 April 2011

Principals of subsidisation

When RebelEconomist went to work in the City (of London) in the 1980s, an important perk of most UK financial jobs was a subsidised fixed-rate mortgage. In his case, this benefit was evaluated as the difference between the mortgage rate actually paid to the lender and a specified concessionary fixed rate, and paid with the employee's monthly salary. The lender was not my employer; at the time, this scheme had recently replaced another in which they lent directly to employees at a low fixed rate. For my employer, the new scheme had the benefits of divesting retail lending, which was not their normal business, and detaching them from the loan so that the benefit could easily be terminated without recovering the loan principal if the employee left and limiting their need to be involved in the event that the employee defaulted on the loan. It strikes RebelEconomist that this kind of approach would be a sensible way to tackle the eurozone debt crisis, and he was surprised not to see something similar suggested in the discussion around last week's European Council meeting in Brussels to consider measures to deal with this debt crisis and prevent repetition. This post explains how such an interest rate subsidy offers a better way of tackling the eurozone crisis than the ideas that have been more commonly discussed so far.

While the causes of the eurozone crisis vary over the countries affected, and in some cases stem from private sector uncompetitiveness or indebtedness, the immediate problem the eurozone crisis presents is a sovereign debt crisis. In some countries like Greece, it was the government itself that had accumulated an excessive amount of debt, although to some extent this reflected a weakening of business activity caused by rising domestic input costs and the depressing impact of the global financial crisis on international trade, resulting in decreased tax revenue and increased welfare payments. In other countries like Ireland, the government had been fiscally prudent, but their private sector had borrowed excessively, and to forestall the turmoil of widespread default during the financial crisis, the government chose to either borrow to bail out the private sector or else effectively take over its debts by guaranteeing them. Naturally, any increase in the loan demand from a particular borrower tends to raise the interest rate that the borrower must pay to raise new loans and refinance existing loans as they mature, but debt crises typically also involve a vicious circle as the additional interest expenditure increases the danger that the borrower will at some point be unable or unwilling to keep servicing its debt, prompting an increase in the risk premium payable on that debt. A debt crisis also decreases the market value of any existing fixed interest rate loans made to the borrower concerned and hence increases the implied market yield on that debt, but, before this debt matures, this is a bigger problem for its holders than the borrower.

A standard benchmark interest rate for sovereign debt sustainability is provided by the expected nominal GDP growth rate of the economy – to the extent that the average interest rate paid on the stock of debt exceeds this level, the country must run a primary (ie not including the interest outlay itself) budget surplus just to hold the debt stock at a steady proportion of GDP. If the country fails to achieve a primary surplus this large, its debt burden (as a proportion of GDP) grows exponentially. Depending on a country's perceived maximum politically-feasible budget surplus and expected economic growth rate (allowing for the fact that fiscal tightening tends to depress economic growth in the short term at least), there will be an interest rate above which the country is effectively excluded from the debt market, because borrowing at such rates makes default practically inevitable. For Greece and Ireland, this critical interest rate has been considered to be about seven percent.

Notwithstanding the so-called "no bailout" clause in Article 125 of the Consolidated Treaty on the Functioning of the European Union (TFEU), which stipulates that "the Union shall not be liable for or assume the commitments of...any member state", the more creditworthy eurozone countries are willing to help its more indebted members for various reasons. Ostensibly, the justification for such support may be that one eurozone sovereign default might trigger a cascade of defaults as alarmed investors shun other marginal countries' debt, potentially resulting in the break-up of the eurozone if defaulting countries reintroduce their own, devaluable, currencies. Such a motive has always been arguably consistent with the provision made in Article 122 for "Union financial assistance" to a member state in "difficulties...beyond its control", but it is now specifically permitted by Article 136, which was amended at the December 2010 European Council meeting to allow eurozone member states to establish a "stability safeguard the stability of the euro area as a whole". In reality, the more creditworthy countries may also be acting in their own self-interest because their banks and pension funds are the troubled countries' creditors.

An obvious way for the creditworthy countries to help the indebted countries is to reduce their interest rate expense. The creditworthy countries could achieve this either by lending them money at sub-market interest rates or by paying the indebted countries compensation for their excess interest costs, but it is conceivable that just credibly showing the willingness to support the indebted countries in some way may be sufficient to cut out the vicious circle that raises the risk premium on their debt, in which case actual assistance might not be needed. To date, as far as RebelEconomist is aware, every assistance scheme that has been used or suggested involves the creditworthy countries lending to the indebted countries directly or indirectly via supranational lending institutions, and thereby taking on the risk that the indebted countries will fail to repay the principal they have borrowed.

Assistance from EU governments and the IMF has so far taken the form of emergency lending to the indebted countries in the event that the market cost of loans to them is deemed prohibitively expensive. The first eurozone emergency loan package was a €45bn three year loan facility for Greece, comprising €30bn in bilateral loans from the (then) 16 eurozone member states and €15bn from the IMF (and therefore partly representing a further indirect loan from all 27 EU member states as well as the other members of the IMF), agreed on April 23rd 2010. Since this amount appeared to be insufficient and failed to stem the rise in Greek government bond yields, it was quickly enlarged to €110bn (split 80:30 between the eurozone countries and the IMF) on May 2nd even before it began to be drawn down by Greece on May 12th. A €750bn loan facility to cover subsequent eurozone emergency lending was introduced on May 9th 2010. This comprises a mixture of loan commitments of up to €250bn by the IMF, €60bn from the European Financial Stabilisation Mechanism (EFSM) and €440bn from the European Financial Stability Facility (EFSF). The EFSM is a loan facility, provided by the European Commission and therefore backed by all 27 EU member states, which borrows the money it disburses in the international capital market (which it is readily able to do as the EU is rated as a triple-A borrower by the major credit rating agencies). The EFSF is a limited liability special purpose vehicle (SPV) owned and severally guaranteed by eurozone member states to 120% of its lending capacity (to ensure its own triple-A rating), which also funds itself in the capital market. On November 28th 2010, Ireland became the first country to take a loan from this facility.

The EFSF is to be replaced in 2013 by the European Stability Mechanism (ESM), another SPV. Although full details have yet to be agreed, it is planned that the ESM will lend up to €500bn and also differ from the EFSF in that (1) its loans to eurozone countries will formally rank above other unsecured loans in the creditor hierarchy and (2) that it will be backed by capital rather than guarantees. Most of this capital will, however, be callable; the difference between callable capital and guarantees being that eurozone countries would be required to pay additional capital into the ESM as the likelihood of loan defaults rises, rather than after a default has occurred.

Enthusiasts for closer European union are wont to see a crisis like the present eurozone crisis as an opportunity to advance solutions involving increased integration. An example is the proposal to extend the EFSF/ESM SPV to borrow on behalf of all eurozone countries as a centralised funding mechanism issuing "euro bonds" and on-lending to each eurozone country as required. Depending on how this European Debt Agency (EDA) was capitalised and/or guaranteed by the eurozone member states and therefore rated by the credit rating agencies, and depending on whether different countries were charged different loan rates according to their creditworthiness, this scheme could be used to subsidise the borrowing of the less creditworthy countries like Greece and Ireland, at the expense of the most creditworthy like Germany and the Netherlands. However, there might be a collective gain if the EDA was able to issue larger and more homogeneous bond issues with a price premium reflecting their greater liquidity.

Another way of ensuring that a borrower is able to obtain funding at an acceptable interest rate is to buy up the borrower's existing debt in the secondary market to hold its market interest rate down so that the borrower can issue new debt at a similar yield in the primary market. In conjunction with the May 2010 IMF/EFSM/EFSF loan package, on May 10th the ECB announced the Securities Markets Programme (SMP) to buy government debt of those eurozone countries with escalating yields, although the ECB somewhat incredibly presented the SMP as a measure "to ensure depth and liquidity...and restore an appropriate monetary policy mechanism". The details of the SMP regarding which countries' debt to buy, how much and at what yield triggers, are left to the discretion of the ECB's Governing Council, but all purchases are funded by reducing collateralised (ie virtually risk-free) open market monetary policy lending to the market in order to sterilise the SMP's impact on the monetary policy stance. Since the eurozone countries capitalise the ECB, the SMP is also effectively backed by callable capital from the eurozone states, and indeed the ECB subsequently did call for additional capital on December 16th 2010.

To relieve the ECB, it has been suggested that the EFSF could buy troubled eurozone government bonds, either from secondary market counterparties or from the ECB to allow it to reduce its exposure to risk. Alternatively, the EFSF could lend to the indebted countries to allow them to buy back their own debt. Since this debt trades well below par in the secondary market, such repurchases funded by new loans would certainly reduce the nominal value of a borrower's outstanding debt, and if the loan from the EFSF is at a concession to market yields, the borrower's interest rate expenditure would also be reduced.

At an informal summit on March 11th 2011, euro area heads of government concluded that the the EFSF and ESM could buy government debt in the primary market in exceptional circumstances. While this is effectively the same as direct lending to the borrower, if primary market intervention is done in conjunction with an issue partly sold or at least offered in the market, it can ensure that the interest rate charged bears some relation to market rates.

In general, these assistance operations are undertaken subject to various conditions imposed on the borrower which ought to make default less likely, but the problem remains that, once the capital has been committed either by being transferred or pledged as callable capital or by guarantee, it is at risk of loss. Direct lending only helps the borrower if the interest rate charged is less than the rate that the market would charge, and unless the lenders are prepared to incur some (expected) cost to themselves to help the borrower, lending at sub-market rates can only be justified from the lenders' point of view if market interest rates exceed the level required to compensate for the risk of default. Similarly, buying debt in the secondary market to hold the borrower's market interest rates down is only cost-free if the market price overestimates the probability of default loss. Considering that some respected analysts consider that Greece and Ireland at least are practically insolvent, despite being assigned credit ratings several notches above the minimum (S&P presently rate Greece as BB- and Ireland as A-), it is not easy to argue that their market yields are unrealistically high. And to the extent that buybacks raise the market price of debt, they give the existing holders of the troubled debt a way out of their exposure with a windfall gain (relative to the pre-buyback value of their holding). Naturally, debt market intervention means that market prices no longer provide an undisturbed guide to market expectations of default losses. Also, if a loan or buyback has proved successful at averting an immediate debt crisis and it is unlikely that further intervention will be required in the near future, having secured concessionary funding the borrower may be less motivated to maintain the austerity required to avoid default.

To RebelEconomist, it seems that a debt subsidy payment scheme like that offered by his former employer could both insulate the creditworthy countries from default losses and give them more control over the assistance they are providing to the indebted countries. Instead of making occasional large capital commitments as loans are disbursed or buybacks are executed, the creditworthy countries would make a stream of relatively small transfer payments to compensate the indebted countries for whatever is deemed to be the excess interest expense on new borrowing from the market. According to the scheme's objectives and constraints, in each case the concessionary interest rate might, for example, be set at a level believed to make the indebted country's debt burden manageable or to match the benefactor countries' funding costs. Given this concessionary interest rate, and the average yield on bonds similar to those to be issued, the size of these subsidising payments can be estimated from sovereign borrowing forecasts. For example, if Portugal is expected to issue €20bn of debt in the next year, and its excess (eg over comparable German bunds) market yield is deemed to be 5%, a payment of €1bn is sufficient to subsidise Portugal's interest cost arising from next year's issuance down to German levels (although of course such payments would grow as long as yields remained at crisis levels). Subsidy payments could be readily adjusted according to the progress of the programme for a particular indebted country, including being suspended if that country stopped servicing its debt or failed to comply with the conditions attached to the scheme, or more optimistically, its economic performance improved so that assistance was no longer needed. Since the subsidy can be curtailed at any time, such a scheme is arguably more in line with the no-bailout clause in the TFEU, because it does not involve the EU or any member state "assuming the commitments" of another member state. This controllability should also make a subsidy payment scheme more acceptable to the benefactor countries' electorates than lending to the indebted countries. Finally, because the scheme would not involve taking over credit exposure from the debt market, indebted country bond yields would serve as a better guide to investors' expectations of default, and loans would not be made at all unless they seemed likely to be repaid.

A likely objection to a subsidy scheme might be that it involves actual fiscal transfers from the creditworthy to the indebted countries, whereas loan capital and guarantees provided via supranational institutions like the ECB and the EFSF do not, but this would be disingenuous – unless market yields really do overestimate the probability of credit losses, loan capital and guarantees can be expected to generate losses in excess of any acceptable interest rate premium charged on EFSF/ESM loans over its cost of funding. Unfortunately, however, unless such probabilistic losses seem likely to be realised within the terms of office of the politicians deciding how to tackle the eurozone crisis, they are likely to be ignored.


Charles Butler said...

Isn't that a deafening silence! Productivity's sure to go up with everyone finally back at their work stations.

But the curious logic governing public perceptions may have made this cheaper, and probably better, plan a harder sell. Ignoring the legalities of which the pundits are so enamoured - nothing works as advertised in the EU - the convenience of being able to hide behind an emergency situation and implement an emergency (read: one off and big) solution trumps the perceived slow and eternal bleed of subsidies.

This all, of course, assuming that they would manage the program properly. If the Common Agricultural Policy is any indication...

Another interesting suggestion put out, that doesn't exclude yours, was that central banks write CDS on their own debt.

RebelEconomist said...

I think you raise a good point, Charles - there is an advantage to solutions which can get past a normally sceptical public while they are worried by an emergency. I doubt whether this approach does much for public support for European integration in the long run though.

I assume that you mean central banks selling CDS on their own country's debt of course! I can imagine an assertively independent central bank being horrified by such an idea, since it practically commits them to monetising the government's debt in the event that the government defaults, although if the authorities are sure that the country will not default, it does allow them to take some money from doubting investors. I would be interested in learning more about this idea if you have a reference to its source.

Charles Butler said...

Found it. You'll note it caught my eye at the time.

With regards to EZ integration: single currency + a zillion euros of German bank exposure to peripheral debt and that's what you've got. The debate is pure (ok, I exaggerate) post-war side show. The reaching of some sort of critical mass by Erasmus kids will have final say on the matter.


RebelEconomist said...

Thanks Charles. I note that the proposal was actually that the governments, not the central banks, write CDS protection on themselves, which raises some other interesting questions, a few of which were considered in the comments to the blog post you gave the link for. I am surprised that a borrower could do this without triggering an event of default, since, if the CDS is collateralised, they are effectively taking a fee to move the protection buyer up the creditor hierarchy. But that is a whole new discussion, in which I have little expertise.

Charles Butler said...

No problem. Sorry for the errors in terminology. Not a specialist in the first place, I hadn't actually gone back and read the post.

Anonymous said...

"I note that the proposal was actually that the governments, not the central banks, write CDS protection on themselves"

I recall hearing that some banks had been selling CDS on themselves before/during the financial crisis. I will try to provide a reference later, as it will require a little digging.