Some view market discipline as a meaningful complementary tool to the political peer review process in order to ensure effective surveillance of fiscal policies. Unfortunately, market discipline does not seem to work well in practice. In the first ten years of the euro, markets underestimated - you could even say completely ignored - the credit risks associated with euro area sovereigns. The underestimation of credit risks is not unique to euro area sovereigns though, and I do not want to discuss the reasons for the past failure to recognise the sovereign credit risks in detail here. However, there is clearly a pro-cyclical element in the overly optimistic risk assessment, aggravated by overly loose monetary policy globally, and a regulatory element due to the zero risk-weighting for government bonds under the Basel II capital requirements. In the euro area, it also might have even been rational for investors to assume that the ‘no bail-out' clause of the European Treaty would not hold, if put to the test.
Over the last two years, we have seen re-rating of the market perceptions of euro area sovereign credit risks. Today, I would argue, markets significantly overestimate the sovereign credit risks in the euro area. However, what's more, we have observed a fundamental regime shift in government bond markets. Rather than viewing government bonds as risk-free, safe haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks (see Arnaud Marès, The Economic Consequences of Greece, August 31, 2011). This has very profound consequences for the stability of financial markets, I think. For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, i.e., rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector. This inherent market instability casts some serious doubts about whether markets should be relied upon as a disciplining factor in the fiscal surveillance of euro area member states. Private sector involvement (PSI) was an exacerbating factor in fostering this regime shift. But, in my view, it is not the root cause. I believe that the root cause is the absence of a lender of last resort to governments.
As individual euro area countries do not have access to a central bank as lender of last resort, all member states' debt instruments are effectively credit risks. True, the bond markets do not view all countries in this way (yet). Germany, at least for now, still seems to be benefitting from a safe haven status. But, this assessment could tilt very quickly if, for instance, Germany and other core countries signed up for ever-larger rescue mechanisms. Just witness the shift in the market perception of France or Belgium at the moment. The absence of a lender of last resort - which, of course, is ruled out by the European Treaty - also implies that even moving towards a fully integrated fiscal union would not remove the credit risk completely (see EuroTower Insights: Fiscal Union Needs Monetary Back-Up to Solve Crisis, September 22, 2011). The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank as a lender of last resort. This recourse ensures that even in very distressed situations government bond investors can rest assured that they will be paid back at par. This is what makes government bonds safe haven assets.
Once aware of the credit risks, financial markets have a tendency to significantly overprice the default risks. Looking at the experience of emerging markets, where we have a sufficient number of empirical observations, we find that in all the cases since the mid-1990s where spreads blew out to more than 1,000bp, in only 20% of cases did a debt restructuring really become necessary to restore debt sustainability. The other 80% of countries actually pulled through without any debt restructuring - though often with the help of an IMF programme (see Cottarelli C. et al. (2010), Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely, IMF Staff Position Note No. SPN/10/12). There are good reasons why the market overprices the risk of default: Defaults are highly disruptive, binary events, which potentially have a big impact on portfolio performance. Around a default, you typically see very sizeable non-linear market reactions, as market liquidity tends to dry up almost completely. Clearly, an unexpected default can also be very detrimental for the career of a portfolio manager who was not mandated to take such credit risks. The steady creep of inflationary pressures, by contrast, is a risk that bond markets typically underestimate. You could even say that inflation is a bit of blind spot for the bond market. Default, by contrast, seems to be a hot button for the bond market. Good, some of you might say. A bit of market discipline is exactly what we need.
Unfortunately, what we observe in euro area government bond markets at the moment is more than just an overshoot in the market's perception of the default risks. The regime shift from risk-free sovereign debt to credit risk actually makes government bond markets unstable. Arguably, it has caused bond markets to become unable to find a new stable equilibrium. This is because bond yields start to move in counter-cyclical fashion: additional austerity efforts which dampen growth cause bond yields to go up rather than down on the back of the perceived increase in the risk of default. The rising bond yields in turn reduce the sustainability of government debt. Fresh concerns about debt sustainability cause a further rise in bond yields. Sprinkle in a few rating agencies re-running their models with the higher bond yields and concluding that a downgrade is (or will soon be) warranted on the back of a deterioration of debt sustainability, and a vicious circle is set into motion.
Once this vicious circle is in motion, I believe that only outright market interventions can restore stability. I am not stating this lightly. In my view, the SMP forces the ECB onto a very slippery slope and, personally, I do not see how the current EFSF iteration can relieve the ECB of its role in the secondary government bond market any time soon. Under the credit market regime, governments have become highly constrained in their ability to stabilise their economies. This is because they are no longer able to borrow cheaply at the bottom of the cycle, and neither are their commercial banks. In addition, governments are undermined in their ability to backstop the national financial sector if needed in face of the ongoing crisis. Hence, rather than exercising market discipline, markets are likely to push towards a sub-optimal equilibrium where even runs on governments are possible. As a result, even solvent governments can become illiquid very quickly. In my view, no euro area country is safe from the regime shift towards credit. We have seen the sovereign debt crisis meandering around the euro area for more than two years now, and eating its way deeper and deeper into the core of the euro area.
Given the statutory limitations on the operations of the ECB/EFSF, it is very difficult, if not impossible, to simply switch back into safe haven mode. Without a monetary backstop, euro area government bonds will not be considered risk-free assets again - in my view, the US or the UK do not fund cheaply because they are fiscal unions, but because they have a central bank in the background as a lender of last resort. In this context, Germany is probably a historical exception rather than the rule. Either markets never really understood that the Bundesbank was banned from monetising German government debt, or we were just lucky that we did not have a sovereign debt crisis during the reign of the Bundesbank.
PSI is a contributing factor - acting as a fire accelerant fuelling the contagion - but it is not the root cause. Euro area government bond markets switched to the credit regime long before PSI was discussed in policy circles. But, PSI gave the official seal of approval to market expectations that restructuring of the Greek debt was unavoidable. While I actually believe that PSI is desirable to avoid moral hazard, the timing of introducing PSI in the midst of the crisis was clearly sub-optimal. Each time, news on PSI seems to have reinforced contagion and triggered a further escalation of the sovereign debt crisis. Introducing PSI into the debate at the Franco-German summit in October 2010 caused Italy and Spain's bond market to become more volatile. Introducing it explicitly into the ESM post 2013 in mid-December 2010 caused a further escalation in market tensions in these two countries. Bringing PSI forward to late 2011 as part of a second Greek rescue package was another mistake, I think. Effectively, a minimal haircut that will hardly make a dent in the Greek debt burden now seems to undermine financial stability in the euro area as a whole by tainting an entire asset class - euro area government bonds. Given the u-turns that we have seen on the PSI issue, markets assign little credibility to the political commitment made in late July that Greece will remain an exception, given that previous commitments were broken. Thus, even a small-scale Greek default would now likely have systemic consequences, in my view.
Eventually, the policy debate needs to be about the monetisation of government debt via a democratically mandated backstop. The current situation with the SMP is untenable, in my view. At the utmost, and that is being generous already, the SMP might be acceptable as a bridge in an emergency situation. It must not become a permanent backstop though. At the end of day, the quick fixes that are applied at the moment could be the seeds of a euro backlash later. I believe that governments need to be clear about how they intend to relieve the ECB of its temporary task (and when) or whether they intend to explicitly amend the ECB mandate to include a lender of last resort function. The present muddling-through is the worst of all options, in my view. The ECB's SMP transforms national government debt into a common euro area liability. From a governance point of view, it would be better if this transformation would take place on the EFSF/ESM balance sheet, where national parliaments can exercise their democratic control function. It would be even better, of course, if national debt was not transformed into a euro area liability at all.
In the right framework, market discipline is preferable to a peer review process in strengthening fiscal surveillance, as even strict fiscal rules do not yield the desired effects. At the national level, fiscal rules get broken all the time (e.g., Germany's strict golden rule under Article 115 Grundgesetz, Gordon Brown's looser, informal golden rule or the constitutional rule in Japan which was broken in each of the last 20 years). At the European level, the Stability and Growth Pact was quickly undermined. Hence, even constitutional rules cannot be fully trusted.
For market discipline to work, one needs to remove the systemic elements, i.e., the externalities between sovereign borrowers that we observe at the moment. At the moment, a sovereign will likely default either on all of its debt or not at all. And as an aside, decision-making amid uncertainty shows that economic agents find it difficult to assign the correct probability to low-frequency, high-impact events. This could be achieved by breaking down the fungibility between the sustainable portion of the overall debt stock and the excessive portion of the debt stock. Slicing sovereign debt into different tranches would allow governments to ‘default by degree', like banks do, for instance. By issuing several different tranches of debt (say ‘senior-sustainable' and ‘junior-not-so-sustainable' debt), the prospect of a sovereign default is no longer binary. Such a tiered structure is similar to some of the proposals for euro bonds, e.g., a widely cited Bruegel proposal (see Jakob von Weizsäcker, Jacques Delpla, The Blue Bond Proposal, May 2010) or a similar idea put forward by my colleague, Morgan Stanley's sovereign economist, Arnaud Marès (see Curing Demotion Sickness, December 6, 2010). Here, the tiered structure is actually applied to national bonds though. Obviously, as a country increases its debt beyond the sustainable level (e.g., 60% of GDP), it would see its marginal costs of borrowing increase noticeably. To make the tiering of government debt even more effective, one could consider making holdings of junior government bonds subject to bank capital requirements on the regulatory side. In addition, the Eurosystem could consider applying differentiated haircuts in its collateral framework to distinguish between the senior and junior government debt.
In addition to limiting the borrowing of euro area sovereigns more effectively, we should also consider excessive lending and its contribution to the crisis. For everyone who has borrowed too much, there is someone who has lent too much. Lenders will often be regulated investors in the core, i.e., current account surplus countries such as Germany or the Netherlands. My sense is that politically a ‘banking union' with federal oversight and a euro area-wide backstop might be easier to engineer than a ‘fiscal union' transferring parliamentary sovereignty to the federal level, and I think policy-makers should focus more here. In my view, financial regulation and supervision should be an integral part of an improved governance system of the euro area.
It is in this area that the ECB can exert direct influence, as all euro area banks need to refinance with the Eurosystem. In my view, it should use this influence more pro-actively in the future.
Out with the Old, in with the New
1. Impact of HICP Methodology Changes
Since January 2011, the treatment of seasonal items in the HICP has been standardized across Europe, in line with a European Commission Directive. This will not only affect the way HICP across euro area countries is estimated, it will also affect the treatment of seasonal items in the UK and French CPIs as well as the Italian FOI.
The methodology change to seasonal items is important for the inflation market for two reasons:
First, a change in the treatment of the seasonal items is probably behind some of the recent surprises in the euro area headline inflation, as a result of base effects (HICP surprised to the upside last week printing at 3.0%Y versus Bloomberg consensus of 2.5%Y).
And second, the changes result in a new seasonal pattern, affecting the relative valuation of inflation-linked bonds (due to different coupon dates). While the impact on euro area headline inflation will likely evaporate in January 2012, the higher volatility in the HICP seasonal factors should remain.
Non-Standardized Approach in the Past...
Before the new regulation on seasonal items came into effect in January 2011, the methodology to price seasonal items varied across countries. The most commonly used method was a ‘carry forward' approach: if data are not available in a given month (i.e., if the item is not in season), then the price of said seasonal item is assumed to stay unchanged from the previous month. In addition, the underlying indices are defined differently across countries. Namely, each country decides what types of products are used in calculating the index's sub-components. Hence, volatility patterns of seasonal sub-components varied across countries in line with the availability of prices of seasonal items.
...Replaced by a Uniform Approach across Countries
In order to improve the comparability of the HICP, the treatment of seasonal products is now consistent across countries. When prices of seasonal items are unavailable in a given month, they are estimated using the available prices of in-season items. Alternatively, weights assigned to the out-of-season items can be changed in such a way that they become zero if prices are unavailable. Both methods, however, should yield similar results according to the European Commission estimates.
The change in the estimation method primarily affects the clothing and footwear sub-component and should be mostly visible in January, March, July and September - i.e., around the sales and when the new collections arrive. But the seasonal food inflation pattern is also changing, which should be most visible in April, May, June and July.
Other sub-components will be affected by the regulatory changes in treatment of seasonal items, but details of some of these sub-components are not yet available. Thus, the impact on the volatility of the seasonal pattern could be somewhat larger. However, the weight of the affected sub-components in overall HICP tends to be very small (e.g., some items in German HICP package tours sub-component, weight: 3.3%). Among the large countries such as Germany and France, we think that the impact of changes in other sub-components is likely to be negligible.
The change in the overall HICP seasonal pattern comes primarily from the adjustments in the Spanish and Italian data. While in Spain the HICP 2010 index has been revised, the HICP index in other countries has been only estimated using the new methodology since January 2011. As the impact of the methodology change differs across countries, the main concern for the future seasonal pattern, and thus inflation-linked bond pricing, are the changes in Italy and those in Spain, in our view.
Initial estimates suggest that Italian inflation has been most affected by the new regulation this year. Given its weight in the overall HICP index (18%), it remains primarily responsible for changes in overall euro area inflation and, together with Spanish data, for the change in the overall HICP seasonal pattern. To a lesser extent, the new regulation impacts German and French HICP inflation, though in a less standardized way.
But the largest euro area countries are not the only ones that have been affected by the new treatment of seasonal items. A similar pattern can also be observed in Portugal and Greece, while in Cyprus, Slovenia and Slovakia the pattern is less standardized. Those countries represent a small fraction of the overall HICP, and thus the change in their treatment of seasonal items should not have a significant impact on the overall euro area pattern, in our view.
2. Estimating the New Seasonal Pattern
Estimating the new seasonal pattern is not a straightforward exercise. First, there are not enough data available to capture the whole dynamics of the new seasonal pattern. Second, before the standardization of the treatment of seasonal items, there were substantial differences across countries in terms of which items were accounted for and when their prices are collected. This makes the approximation more complex. In addition, the breakdown of data beyond the clothing and footwear or seasonal food sub-categories is not available.
2011 year-to-date data is a good candidate to approximate the new seasonal pattern in the remainder of the year. This is because the acceleration in oil prices in 1H11 was rather short-lived and demand conditions remain relatively stable. Our final seasonal pattern estimates net out inflation, so that monthly seasonal adjustments sum to zero. We are analyzing an impact from two sub-categories: clothing and footwear and food.
The introduction of the common treatment of seasonal items increased the volatility of the clothing and footwear subcomponent, but has the advantage of standardizing the pattern across countries. Previously, prices in Italy tended to experience a more rapid increase in March, whereas in Spain the peak was in April.
By observing the pattern changes in the Spanish HICP and the Italian year-to-date data and the corresponding peak and trough, we derive the estimates for the monthly changes in the reminder of this year in the clothing and footwear subc-omponents - driven by the occurrence of sales periods.
In order to derive the overall change in the clothing and footwear sub-component for the euro area HICP, we perform the same estimation for Germany and France (where an impact was seen in the after-sales period), and for Greece and Portugal - courtesy of large price swings in these countries.
The new methodology has not affected all food prices year to date, as up until now monthly volatility has only increased in Spain and Italy with respect to fresh fruit and vegetables prices, while monthly volatility of fresh fish prices (weight 0.38%) has not changed substantially. While clothing and footwear monthly price changes are determined by sales periods, the food seasonal pattern is determined by weather conditions and it tends to differ along the year. As there are not enough data available at this stage, we assume that the seasonal pattern of food prices will remain largely unaffected by the methodological changes in the reminder of the year. It is supported by the Spanish statistical office study, showing that an increased price volatility resulting from methodological changes tends to show up in the first half of the year and be marginal in the second half. What's more, food prices are less volatile overall compared with clothing prices and thus statistical adjustments should have a much smaller impact on the overall HICP pattern (weight of seasonal food: 3.8%).
For full details, see Economics & Strategy: New Euro Seasonality, October 4, 2011.
A second in-year revision to the 2011 budget: On October 3, the Russian MinFin published a proposal on its website for a second revision to the 2011 budget, which is due to be submitted to and voted on by the State Duma this week. This follows the June budget revision, which increased expenditure by 3.4% and revenues by 16.5%.
Now, Russia plans a balanced budget... Previously, the expected deficit of the federal budget was forecast at a token RUB 29.9 billion or 0.1% of GDP. However, the revised proposed budget now sets expenditure and revenues at an identical RUB 11.1 trillion, and revokes the clause in the budget law authorising the government to run a deficit.
...which, we think, in practice means a surplus: We have several reasons for now expecting a small surplus, in practice. First, the federal government now does not have the authority to run a deficit. Second, since there are always bottlenecks in spending on some items, and authorised funds can in general not be moved from one item to another, we are sceptical that the government will execute all authorised expenditures. However, since it is an election year, we think that there will be significant pressure to spend the budget in full, so we expect the full-year surplus to be relatively small.
Buoyant revenues underpinned by oil, imports and payroll tax hikes: Federal revenues are revised further up by 25.8% to RUB 11.1 trillion from the original December 2010 plan of RUB 8.8 trillion or 7.9% up from the first revised June budget of RUB 10.3 trillion. We see three key causes of the higher-than-expected revenues:
• The higher-than-expected average oil price, which at US$110/bbl year to date is well above the original budget assumption of US$75/bbl and the revised June assumption of US$105/bbl. We estimate that US$1/bbl on the oil price adds US$1.8 billion to full-year revenues;
• Strong import growth, which has been running at 34%YTD or US$51 billion higher than last year. Imports are more heavily taxed than domestic products; and
• Higher payroll taxes, following the January hike in social contributions from 26% to 34% of pay.
Budget execution not at threat from the recent market sell-off, we think: Clearly, a decline in oil prices would hit 4Q oil taxes, and a decline in imports following the weakening of the RUB would reduce 4Q import taxes. However, we do not think that execution of the 2011 budget will be constrained by funding, even without a deficit, for two reasons. First, the MinFin has built up a huge cash surplus as a result of the large budget surplus in 1H11 (3.1% of full-year 2011 expected GDP in 1H) and the MinFin's RUB 781 billion in net OFZ borrowing. In fact, as of August 1, the MinFin had RUB 2 trillion or nearly 4% of full-year 2011 expected GDP in the Treasury account. Second, the revenues from oil are paid in dollars and so yield more RUB at a lower exchange rate.
Aggregate expenditures flat... By comparison, the revision to aggregate expenditure is a minor adjustment of 0.9% or RUB 100 billion to match revenues.
...but a clear shift in composition: Although no clarification has been published, looking through the details, we identify:
• A RUB 132 billion reduction in spending, mainly on debt service, as a result of reduced borrowing;
• Significant increases for the military, including veteran housing, social payments and defence procurement;
• An increase in industrial subsidies for state-owned companies, including ~RUB 40 billion for Russian Railways, RUB 40 billion for Rosselkhozbank, the state-owned agricultural bank; RUB 22 billion for Rosnano, the state high-tech venture capital fund; and RUB 22 billion for Rosatom, the state nuclear power corporation; and
• An intriguing reference to an additional RUB 180 billion for the pension fund, which could be to fund an additional pre-election pension increase of 10%, which was discussed earlier this year but not implemented as a result of uncertainty about the budget.
Where's the pre-election stimulus? At the first glance, the picture of a budget surplus doesn't fit with our prediction of a pre-election spending increase. However, if we look at budget execution year to date, we see that the government has been running a large surplus, amounting after seven months to RUB 756 billion at the federal level and RUB 886 billion at the local government level, or 3.1% of full-year expected GDP. Assuming that the government actively pursues execution of the programmed balanced budget, even with a ‘frictional' surplus, this implies injection of nearly 3% of GDP into the economy before year-end.
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