Eventually, the policy debate really needs to be about the monetisation of government debt via the central bank. Don't get us wrong, we are not advocating the monetisation of government as an easy solution. As many of our regular readers know, we think inflation is more of a risk than deflation and we are fully aware of the grave long-term consequences of inflation. We have, however, come to believe that the monetisation of government debt might need to be considered as the ultima ratio - the last resort. In this note, we explain why.
At present, the ECB is being forced onto a slippery slope by European governments, who are delaying addressing both national economic policy reforms and institutional innovations to the governance of the euro area as a whole. The ECB has been forced to take unprecedented financial and political risks with its various open market operations, ranging from its unlimited refinancing operations to its securities market programme (SMP). More than many lawmakers and the public at large might realise, a quasi-fiscal union is currently being created through these open market operations on the rapidly growing ECB balance sheet. Not only does the SMP blur the responsibilities between fiscal and monetary policy without there being a clear legal and institutional framework in place, but also national sovereign debt is being transformed into a pan-euro liability at a fast pace on the ECB balance sheet. In our view, this grey area of unprecedented crisis management needs to be clarified urgently by European governments and put to vote in democratically elected parliaments alongside fiscal austerity packages, the amended Stability and Growth Pact and other institutional reforms. Otherwise, we see a serious risk of an undermining of the effectiveness and credibility of one of the very few European institutions that have proven to be fully functional: the ECB.
From a market point of view, it is the government's recourse to the central bank's printing press that separates sovereign debt from other forms of debt. As a result, government bond investors are reassured that even under distressed circumstances they will be repaid in full at maturity - if needed, by freshly minted money created by the central bank that acts as a lender of last resort. This is not to say that these countries would use the central bank's printing press to inflate away the debt burden - even though this is clearly a risk and one that has to be taken seriously. But there is ample empirical evidence that investors fear defaults much more than inflation, given that the former is much more disruptive to markets and especially to the financial system where government bonds play a very special role. As a result, otherwise solvent governments can experience self-fulfilling runs on their debt if they don't have recourse to the central bank as a lender of last resort. If designed properly, the monetisation of government debt would be an insurance mechanism that in actual fact would never be used. As we make this argument, we clearly recognise the risks of governments who are unwilling to adhere to fiscal discipline shifting their fiscal responsibilities to the central bank. This is exactly what we are witnessing in the euro area at present.
Without a monetary backstop, however, euro area government bonds are not considered risk-free assets by hold-to-maturity investors such as banks. Instead, government bonds have become credit risks. This has fundamental consequences for the functioning of financial markets and for their stability. We can observe this shift in rather dramatic fashion in different euro area government bond markets at the moment, where, one by one, sovereigns are being reclassified as credit risks (see Laurence Mutkin, When Is a Government Bond Not a Government Bond? September 22, 2010). Importantly, this reclassification in the mind of investors causes funding costs of sovereign borrowers to become pro-cyclical. Normally, government bond yields would fall when the economy slows. Credit risk premiums, by contrast, rise when the economy slides into recession. Evidently, even austerity programmes can no longer induce bond yields to fall. Instead, the concerns about the negative impact of lower growth push the credit risk premium higher and higher so that bond yields actually rise rather than fall when growth slows down. As a result, governments can become highly constrained in their ability to stabilise the economy in a downturn and, importantly, the financial sector (see Arnaud Marès, The Economic Consequences of Greece, August 31, 2011).
More importantly, it seems to us that the credit segments of the euro area government bond market are no longer able find a new stable equilibrium. Instead, a spiral of weaker growth and higher yields further undermines the sustainability of government debt without the prospect of convergence to a new market equilibrium near term. To boot, significant overshooting up to and including vicious circles seems to characterise market dynamics. Such overshooting is problematic because it triggers fresh investor reactions and rating agency action. This market reaction that pushes bond yields higher rather than lower on the back of growth concerns is the source of the instability, not the fact the fiscal austerity weighs on near-term growth. While the economic adjustment process converges to a new stable equilibrium (given that the fiscal multipliers and fiscal stabilisers are smaller than one), the market adjustment process does not seem to do so once government bonds are viewed as credits. This necessitates intervention by the EFSF and/or the ECB to prevent an otherwise solvent country from becoming illiquid. The first 12 years of the euro provide ample evidence that market discipline does not work when it comes to fiscal policy.
In industrial countries issuing debt in domestic currency, recourse to the central bank's printing press acts as an insurance against a vicious cycle in market sentiment. In the euro area, the monetisation of government debt would mark another step change in the policy response - one that would be even more controversial politically and legally than the creation of a fiscal union and joint issuance of euro bonds. For one, such a change of the EU Treaty, which bans the ECB from funding governments, would likely be brought in front of the German Constitutional Court (where this challenge could have a higher chance of success than the cases brought recently given its Maastricht ruling in the early 1990s). For another, the monetisation of government bonds could pave the way for Germany and a few other core countries to begin contemplating leaving the euro in order to reinstate a hard currency regime. Hence, rigorous fiscal discipline is an even more pressing policy need. Given the tendency of elected governments to never consider it the right moment to rein in budget deficits and pay down debt, strict fiscal rules at the constitutional level would be essential.
The aversion to the monetisation of government debt in Germany likely runs much deeper than the inflation angst caused by the hyperinflation of the 1920s. This aversion reflects the fact that the central bank printing press was used twice in the 20th century to fund major wars. After the Second World War, it was therefore decided that the predecessor to the Bundesbank should not take any instructions from the newly established West German government even though it was initially to be directed by the Allied Forces. Like the restrictions on other elements of the German constitution, e.g., its electoral system or the federal structure, banning the Bundesbank from funding the government was intended to limit a concentration and centralisation of power within the newly established Federal Republic. The post-war Wirtschaftswunder caused the German population to become much more attached to their independent central bank than their elected governments. The hard currency regime that the Bundesbank provided resonated well with a population that has memories of hyperinflation and subsequent currency reforms. Thus, the desire to fiercely protect the independence of the central bank runs much deeper than just the inflation angst.
Arguably, the creation of a fiscal union and joint issuance of euro bonds, if designed well, could bring about a material improvement in the perception of the credit risks associated with euro area government bonds. A badly designed fiscal union, which does not ensure sufficient fiscal discipline, by contrast, could be what eventually causes the monetary union to come undone. One of the authors of this piece warned about this back in 2004 when Germany and France watered down the Stability and Growth Pact (see Joachim Fels, Euro Wreckage? January 22, 2004). The quantum leap that ECB President Trichet demands of the eurozone government could potentially address one of the birth defects of the euro, which remains a monetary union without a political or, at least, a fiscal union. The joint issuance of euro bonds could help pool individual country credit risks and, depending on their liability structure, could provide a certain guarantee structure for investors. Contrary to the bonds issued by the EFSF, which only carry a pro rata liability, almost all euro bond proposals are advocating a joint liability of all euro area countries for at least part of the debt stock. The inherent risk in such a structure is that it has a high propensity to create moral hazard and hence could lead to large scale fiscal transfers - such as the German Laenderfinanzausgleich.
At present, policy-makers worry about the appropriate design of a fiscal union - and whether to go that route at all - as well as the joint issuance of euro bonds. The first attempt with the original Stability and Growth Pact clearly failed to establish fiscal discipline. Market discipline did not work either and we are starting to doubt whether it would ever work. But over and above these serious policy design issues, our main concern remains that even a perfectly designed and implemented fiscal union and joint issuance of euro bonds might not be sufficient to end the sovereign debt crisis. This is because a fiscal union will only reduce the perceived credit risk, not remove it. To remove the credit risk (which seems to be causing unstable markets) and re-establish euro area government bonds as sovereign debt, the euro area will need to have a backstop with unlimited capability to provide liquidity: Alas, this can only be done by the central bank. Thus, a fiscal union is only a precondition for allowing the ECB to monetise government debt in extreme situations where ECB intervention is deemed the ultima ratio.
The current situation with the SMP is untenable, we think. It might be acceptable as a bridge, but it must not become a permanent backstop. If governments want the ECB to monetise their debt, they need to mandate it properly. There can be no mistaking that at present the monetisation of government debt by the ECB is ruled out by the European Treaty (see Article 123). Some observers would argue that the ECB is probably already bending the rules with its SMP as it likely is a violation of the spirit of the treaty, even if you can still (just about) justify it to be compatible with the letter of the treaty. Hence, it is not surprising that the controversial decisions to start and then to extend the SMP have already led to two high-profile resignations from the Governing Council. We believe that the slower governments are in bringing about a quantum leap in eurozone governance, the more joint financial risks will likely end up on the ECB balance sheet and the closer we get towards what is effectively not just the mutualisation but also the monetisation of national government debt. The ECB is being forced onto a very slippery slope, given that its mandate also includes an obligation to help governments safeguard financial stability. Governments need to be clear whether they intend to relieve the ECB from its temporary task soon or whether they intend to amend the ECB's mandate to include a lender of last resort function. The present strategy of ‘muddling through' is the worst of all options, we think.
The ECB's SMP transforms national bond markets into a euro area common liability, a liability that is backed by euro area governments via a loss-sharing agreement (for details on the ECB balance sheet, please see the Appendix at the end of the full report). This is obvious from the sterilisation of the SMP purchases. The ECB has several alternatives to sterilise its bond purchases: offering short-term deposits or issuing ECB debt certificates. Currently, the ECB is using short-term deposits to remove the liquidity added by the SMP's bond purchases from the interbank market. If the ECB instead decided to issue ECB debt certificates, it would be obvious that it is hovering up national government debt from the secondary market (rather than the interbank market) and transforming it into a euro security on its balance sheet. But this is not different for the short-term deposits it currently offers. Given that the short-term deposits are eligible collateral for the ECB's refi operation, they are quasi-money anyway.
From a governance point of view, it would be much better to do this transformation of national debt into euro area debt on the EFSF or ESM balance sheet where national parliaments exercise their democratic control function. In our view, it would make sense to consider leveraging up the rescue mechanism. The European Investment Bank (EIB) could be a blueprint, we think. Not only would the transformation of national sovereign debt into euro area-wide debt no longer happen on the ECB balance sheet, but the ECB would also still have the discretionary decision as to whether it would make an ESM-bank an eligible counterparty to its repo operations. Like all other banks, the collateral that the ESM bank would post to the ECB (in particular the government bonds it bought in the secondary bond market) would be marked to market on a daily basis and be subject to the normal haircuts the ECB applies.
This would clearly offer the ECB much better protection against potential financial risks if the sovereign debt crisis escalated further than the SMP. The SMP purchases are accounted for at purchase costs as they are intended to be held until they mature. Hence, any loss in value of the government bonds purchased by the ESM-bank would immediately shrink the collateral pool. Even though this would not lead to direct losses at the ESM-bank, where the bonds would likely be held as hold-to-maturity assets, the ability of ESM-bank to fund might be affected, thus creating strong incentives for governments.
The monetisation of government debt via a state-owned bank will likely also be controversial on the ECB Governing Council. True, the ESM-bank can create additional liquidity, but this is not different from any other commercial bank that funds its government bond purchases at the ECB - a phenomenon that was widely observed after the ECB launched its first one-year tender and that we have always referred to as indirect QE. Short of a complete overhaul of the European Treaty to lift the ban on monetisation of government debt by the ECB alongside the introduction of a closer fiscal union - which would certainly require referenda in several countries and would likely irk the German Constitutional Court - using a levered form of the ESM to conduct purchases of government bonds in the secondary market would seem a viable second-best policy option.
Ukraine faces an external financing challenge: As we argued last week (see Ukraine: Funding Challenges Make IMF SBA the Best Option, September 12, 2011, for details), the main challenge Ukraine faces in the current circumstances is funding. In 2012, even with the IMF programme, Ukraine faces a challenging government debt service hump of 3.3% of GDP, up from 1.8% in 2011, as well as maturing external debt of 35% of GDP, up from 26% at end-2008. Without the IMF programme, the Ukrainian authorities' funding challenge would increase to over 5% of GDP in both 2012 and 2013. In the current risk-averse environment, we argued that the Ukraine authorities would have no alternative to the IMF loan.
The gas tariff standoff: However, it appears that the Ukrainian authorities do not agree with this analysis. Last week, the IMF resident representative to Ukraine insisted that a substantial hike in domestic gas tariffs remained a precondition for release of the next tranche of IMF funding, while the First Deputy Prime Minister Kluyev vowed that there would be no hike in domestic gas tariffs. This looks like an impasse: no tariff hike = no completion of second review = no additional IMF funding.
IMF position on gas tariffs: The IMF's position has a substantive and a procedural element. Substantively, it argues that the low domestic gas prices are a main source of Ukraine's persistent current account and fiscal deficit, and that restoring macroeconomic stability requires tackling this structural imbalance. The IMF points out that the deficit in the distribution arm of Naftogaz is in the order of 2% of GDP. The scale of the deficit is partially masked by profits in the transportation and exploration arms of Naftogaz, but with the loss of some transit business as the Russian NordStream pipeline diverts some transit volumes away from Ukraine, and the prospect of South Stream diverting the remaining transit volumes away from Ukraine, Naftogaz's deficit is set to widen significantly if no further action is taken. Procedurally, the IMF argues that the Ukrainian authorities committed to raise gas tariffs by 50% in April 2011, and that a significant hike remains a precondition for access to funding. The IMF has indicated that it would be flexible about the exact form of the hike - for instance, it agreed previously to a two-stage schedule of hikes of 20% and 10% earlier this year - and would support additional spending to offset the impact on low-income households. However, we think that the IMF is determined to require domestic gas tariff hikes as the price of additional funding. If anything, the failure of the Ukrainian authorities to implement an agreed schedule of tariff hikes twice in the course of a year is a sign of the difficulty of achieving political agreement on raising tariffs, and has reinforced the determination of the IMF to tackle the underlying deficit of about 2% of GDP, on the grounds that it would not, in the absence of a programme, be tackled.
An additional attraction of the gas tariff hike is that it can be implemented and verified before funds are disbursed, whereas there is a risk that a tight budget passed before a tranche is disbursed, for instance, may be subsequently amended.
Government position: The government argues that it is not the business of the IMF to intervene in the detail of spending. As long as the authorities deliver the agreed macroeconomic parameters, then it is a matter for the government to decide on the composition of tax and spending. Since the 2012 budget now includes a large transfer to Naftogaz of UAH 12 billion (0.8% of GDP) to cover the cost of the ongoing household subsidy, the IMF has no locus, the government suggests. Moreover, argues the government, gas tariffs need to be raised in a sustainable and gradual manner. Sharp hikes may just provoke non-payment and politicise the issue. The focus should be initially on raising the current low level of compliance (just over 50%) with payments for utility services such as heating and hot water, which will in turn translate into higher payments from the utility companies which provide these services to Naftogaz. Looking ahead, further key steps in moving Naftogaz to sustainability could include: i) capping the cost of social welfare beneficiaries in Ukraine, where 17% of the population is assessed as having the welfare status of a Second World War veteran, as opposed to 4% in Russia, and who qualify for free or heavily subsidised gas; and ii) restructuring Naftogaz so that the divisions operate on an arm's length basis, which in turn will require gas pricing to cover the cost of the 6 billion cubic metres (over 10% of Ukraine's annual gas consumption), which are consumed within Naftogaz annually for transport and losses.
Reform fatigue setting in? Our view is that the government recognises the importance of tackling the Naftogaz deficit, but is particularly concerned about the impact of raising domestic gas tariffs on the popularity of the president and government, which has been in steady decline since the elections last year, and would rather postpone any difficult decisions to the other side of the parliamentary elections, due in October 2012. The government has also been hoping that Russia would agree to a discount on the price of gas imports, which would reduce the need for a domestic gas hike to reduce the deficit. However, this option now appears to be off the table, since Kiev is not prepared to pay Russia's price, which is either selling a stake in its gas transportation system to Gazprom or entering the Russian-led Customs Union. Now the government is hoping that it can raise needed financing from alternative sources.
Will the deficit be 3.5% of GDP in 2011? At the moment, there is also a disagreement about the size of the Naftogaz deficit this year. The IMF see a higher deficit, and therefore a risk that the broad budget deficit will exceed the programmed 3.5% of GDP, while the government believes that Naftogaz revenues will recover in 4Q, narrowing the Naftogaz deficit and keeping the broad budget deficit within the programmed 3.5% of GDP. One reason for delaying the mission at least until the end of October - which probably implies a delay in first disbursement of the next tranche to the start of 2012 - is to allow more data to be collected to resolve this disagreement.
Keeping the IMF warm: At the same time, Ukraine appears, in our view, to be making every attempt to keep the IMF warm. Ukraine has made an impressive amount of progress on the IMF programme, including by enacting a major pension reform, and a fiscal consolidation of around 3% of GDP this year. The gap between the parties - on gas tariffs and the 2011 deficit - could be relatively quickly resolved by a hike in gas tariffs. We think that the authorities' objective is to minimise the size of the tariff hike that the IMF will require in the event that IMF lending is required, while maintaining the option of accessing the IMF funding at short notice, in the event of a drain on reserves.
How much would be enough? Tariffs were last hiked in August 2010, so a circa 10% increase would be required just to match inflation since then, and a more than 15% increase to ensure that prices at the end of the 2011-12 heating season are no lower than in August 2010. In fact, we are sceptical that the IMF will budge further from its current position, which is a 30% hike. First, gas prices are still low by international standards. Second, low domestic gas prices and the resulting inefficient use of energy is a primary underlying cause of Ukraine's persistent balance of payments and fiscal deficits.
Households are the largest consumers of gas, but face weak incentives to reduce consumption: Households consumed 17.3 billion m³ or 38% of total gas consumption in Ukraine in 2010, according to Naftogaz data. After the 50% increase in gas tariffs in August 2010, the fall in consumption was only 1.2% for households and 7.0% for utility enterprises year to date (as of August 2011), reflecting the low elasticity of consumption at these price levels. Although household domestic gas prices have increased, they remain comparatively low. On the basis of actual payments, we estimate that Ukrainian households in the first seven months of 2011 paid US$65/1,000 m³, compared to US$73 in Moscow and about US$600 in Germany. As a result, the incentives to cut gas consumption are comparatively low.
The search for alternative sources of financing is on... In the meantime, the authorities are actively engaged in seeking additional funding. Since domestic yields are high, reflecting the shortage of liquidity since the NBU tightened policy at the end of July, the MinFin is focusing on raising funds from external sources rather than the OVGZ market, in particular by reopening the Eurobond, which has raised US$2.75 billion this year already, and by seeking to roll over the US$2 billion VTB Capital loan, which matures in December this year. The government is also reviewing the privatisation programme, which could contribute to the funding. At the same time, the NBU is developing a range of additional instruments, including gold-backed certificates, to tap additional sources of domestic saving.
...but we think that external financing will be scarce and expensive... Given the current state of markets, and the 2012-13 funding hump, we think that raising this financing in the absence of an IMF programme will be extremely challenging. Moreover, it could be counterproductive if it locked in a high yield, and validated concerns about Ukraine's creditworthiness. Although Ukraine's current CDS is an order of magnitude below the 5,431bp peak it hit in March 2009, and the Ukraine CDS spread over most European credits has improved recently, it has nonetheless climbed over 200bp since the beginning of August, and it is now higher than at any time since the current IMF programme was announced in July 2010.
...and domestic funding should be raised primarily through the OGVZ market: We think that the NBU's efforts to raise domestic funding through additional domestic instruments may be a useful complement to other measures, but the best way to raise domestic funding is through the OGVZ market, and this will only be possible at an acceptable price when the NBU is able to loosen policy, as a result of a reduction of pressure on reserves and the currency. At the moment, with the NBU keeping liquidity tight, we believe that yields are too high to be acceptable to the MinFin and there is little new OGVZ issuance.
Ukraine has not struggled to finance its current account deficit this year... Ukraine's international reserves have increased this year by 10.4% to US$38.2 billion, or 4.5 months of import cover. In particular, Ukraine has been successful in funding the current account deficit in 1H11 due to Eurobond issuance, notably by the government, and privatisation. The seven-month cumulative current account deficit is at 3.9% of GDP year to date, with our year-end forecast at 4.0% (see also Ukraine: CA Deficit Narrows on Stronger Grains and Metals, August 9, 2011).
...but we see significant financing risks: In general terms, Ukraine requires an ongoing inflow of capital to finance its current account deficit. There are a number of specific risks which could turn the current net inflow into an outflow:
• Population demand for forex, which remains high at an average US$880 million per month in 2011, could increase further;
• Foreign bank subsidiaries in Ukraine, which repatriated US$1.6 billion in 1H11, could come under pressure to accelerate the repatriation of capital to their parents, particularly in connection with funding problems in Europe.
• Short-term external debt on a remaining maturity basis has increased sharply. On our calculations, about US$67 billion of external debt or 35% of GDP is due to mature in 2012, up from 26% at the end-2008. This clearly poses a risk that lenders may demand repayment and be reluctant to roll over the short-term debt.
IMF - the lender of last resort: We therefore stick to our previous conclusion. The authorities will seek to raise financing to cover their external financing gap from external and domestic sources at an acceptable price. However, these efforts are unlikely to be successful and, combined with the fragile situation on global markets, are likely to trigger a drain on the reserves. This, in turn, will likely force the authorities to raise gas tariffs to complete the second review and secure the next tranche of funding from the IMF - Ukraine's lender of last resort.
Read Full Article »