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May 15, 2018

Commission to press ahead with ESBies

FAZ has a story this morning that the European Commission is putting its weight behind ESBies (European safe bonds). It reports that Valdis Dombrovskis will make a proposal next week for debt instruments backed by sovereign debt, known in the Commission as sovereign-bond-backed securities (SBBS). The paper writes the proposal is based closely on the original 2011 paper by Markus Brunnermeier and others. The idea is to pool the sovereign debt of all eurozone countries in relation to their ECB capital key, and to create two tranches. The larger and more senior tranche would be the so-called ESBies - the more secure bit - while the remainder would be junior. The bonds in the upper tranche would lose their status only if a state failed to service more than 30% of its debt. The junior bonds serve as buffer for the senior bonds. 

As FAZ points out, the Commission hopes to increase the supply of top-rated bonds in the eurozone through this device, without going through the inconvenience of having to create a mutualised debt instrument. SBBS are not eurobonds. The Commission emphasises that the sole purpose of these instruments is to reduce risk in the banking sector. They would also help banks diversify away from the national debt of their home state. 

FAZ points out that this construction is not acceptable to Germany. The German position is to reduce risk by subjecting bank holdings of government debt to risk-weighted capital requirements, or by limit concentration of banks' holdings of government debt by imposing quantitative ceilings. 

FAZ quotes a recent comment by S&P, which wrote that it would not grant an ESBie the top rating desired by the Commission. The paper quoted S&P as saying it would rate the ESBie at the same level as the lowest-quality bond in the upper tranche. The paper also quoted the economic advisory council of the German economics ministry as pointing out that, if there were a genuine demand for such products, they would already have been constructed by the private sector. This is not happening because there is no demand. 

Werner Mussler compares ESBies to the attempt to square a circle. He says the Commission knows that its SBBS will not fly, especially in view of the comments by S&P. This leaves only one explanation: that the proposal embeds a hidden agenda to secure the SBBS with a eurobond.

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May 15, 2018

Draghi on risk sharing and risk reduction

Last week was marked consecutively by Europe's Day, the Charlemagne prize, and the conference on the state of the union at the European institute in Florence. And this year, just as the Charlemagne prize recipient Emmanuel Macron made an ambitious speech on eurozone reform, Mario Draghi did likewise in Florence. Speaking on the topic of risk reduction and risk sharing, he for the first time advocated explicitly for a fiscal backstop for eurozone bank resolution. We think it is significant that Draghi does this, but we have not noticed that his speech has attracted much attention outside of professional ECB watchers.

Draghi observes that a monetary union involves a trade-off: the monetary sovereignty that members give up is balanced by new adjustment mechanisms at the aggregate level. In the case of the EMU, these adjustment mechanisms are by design centered on the private sector. Draghi notes that in the US, which is a long-established monetary union, private sector adjustment works fairly well but is also balanced by significant fiscal intervention by the federal government. In the case of the eurozone, private risk sharing still needs to develop across national borders. And the development of private risk sharing needs the support of the public sector. Deeper monetary union is necessary for private risk sharing to build up sufficiently.

For Draghi, European bank supervision is working relatively well but common bank resolution is incomplete because of differing national regulations on insolvency. What is missing for Draghi is a fiscal backstop for bank resolution. A bank-financed fund for resolution can become overstretched by a large crisis, and there is no substitute for the open-endedness of a fiscal backstop. This is explicitly not about bailouts, but about funding for resolution through loans. The US system, with the federal deposit insurance corporation FDIC backstopped by a credit line from the US Treasury, compares favourably to the European situation. Similar fiscal backstops exist in the UK and Japan.

Draghi admits that it is not simple conceptually, legally, or politically, to introduce a common fiscal backstop into the EMU. But it must be done because risk sharing and risk reduction are not a dichotomy or a tradeoff, but mutually reinforcing. Risk reduction needs risk sharing like risk sharing needs risk reduction.

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May 15, 2018

Setser on the eurozone's export reliance

Brad Setser has an interesting post of the over-reliance of the eurozone on net exports, and the role Ireland plays in this. His figures of annualised contributions to GDP growth shows that net exports became more important for growth in 2017, contributing 1.2pp to GDP growth, while domestic consumption fell in the second half of 2017. Ireland has been one of the main contributors. In terms of GDP, its size is only 2-3% of the eurozone's GDP. But its exports are important beyond its size due to international companies like Apple using Ireland as their European base for tax purposes. This not only messes up the GDP data for Ireland, but for the eurozone too. His calculations shows that Ireland accounts for half of the eurozone's net exports. For domestic demand the Irish contribution actually takes away nearly half of a percentage point. So, if Ireland is left out of the eurozone figures, the composition changes. Exports still matter, though, and the export reliance of GDP growth increases significantly in 2017. Even if there is no data out yet for the first quarter in 2018, it is not far-fetched to expect that this trend continued. There is an overly tight fiscal policy in Germany, as well as in France and Spain, which is likely to outweigh any Italian stimulus. Many in Ireland stopped using GDP data as a meaningful measure for the country's economic performance. Maybe the eurozone should think about something similar as well?

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