Archive for November, 2011

Pay It Forward: Emergency Eurozone Liquidity Without Begging the ECB

November 24, 2011

The severity of the financial crisis is down to savers no longer “knowing”* what saving goods (especially bonds) are worth. While the crisis reflects major underlying problems, its immediate escalation is simply a draining away of liquidity from almost all saving goods. The one exception – so far – is money.

A holder of an Italian or Spanish government bond knows that it is backed by a promise made on behalf of million of taxpayers. Yes, both economies (as with all others in the developed world) are mired in difficulties of some description or other. But this diagnosis is not entirely new. Have Italian and Spanish workers all suddenly become less productive? No. Has the word of their sovereigns become questionable all of a sudden. No.

For all the theory directed towards macroeconomics, what causes a recession to occur after a period of growth is confidence. Factors of production – land, labour and capital – do not undergo sudden changes. Yes there are recurrent supply shocks, such as rising commodity prices, wars and natural disasters. But nobody is arguing that any of these is to blame for the current crisis.

Meanwhile, very many people recognise that confidence is key. Keynes talked of animal spirits, and this concept has recently made a comeback in the English language. Behavioural economics has never been more influential.

Yet this level of understanding among policymakers has not unlocked the present conundrum. The more savvy do realise that the key to de-escalating the Eurozone financial crisis is to furnish savers with a saving good whose worth they “know”*. So far, this has prompted calls for the provision of more money (ie ECB intervention). It is beyond the scope of this note to detail the difficulties of such a proposal – suffice to say there are major political impediments.

But as I argued recently (“Dear Mario: A Plan for Italy”**), formal ECB-driven quantitative easing (QE) is not required. No ECB intervention is needed for eurozone sovereigns to issue an instrument whose worth can never be in doubt. Previously this instrument was a government bond, although in this emergency savers now question whether distressed sovereigns are capable of honouring their promises. So a new instrument must be established.

This instrument is a Tax Credit. What distinguishes this from a conventional bond is that the worth of a Tax Credit (to a taxpayer in the year of exercise) is self-evident. This worth is independent of what other savers think or how they behave; it does not rely on a sovereign being in rude financial health in the future. A Tax Credit resembles money much more than it does a bond.

Whereas formal QE cannot be achieved by Italy or Spain (without abandoning the euro) – and might not even be feasible for the ECB given its political environment – Tax Credits can be issued by any sovereign unilaterally with immediate effect simply by offering to subscribe a sum of government bonds in exchange for another sum of Tax Credits exercisable in the future.

Whereas savers (who cannot know for sure what government bonds are worth) demand very high yields to hold bonds issued by distressed sovereigns, they would not have this concern about Tax Credits. Like money, their liquidity is as assured as taxes being levied. Consequently, the terms of the exchange would reflect a much lower (truly risk-free) rate of return: the opportunity cost of holding a Tax Credit (for the taxpayer) is the liquidity premium (on account of the delay before its exercise, at which date it is a cash equivalent).

The government would announce an auction/exchange date together with the sum of Tax Credits being offered (with different years of exercise). Using a risk-free rate of return to accrue value, a maximum exchange rate would be set. E.g. up to EUR110 of 10Y Tax Credits could be offered for EUR100 of 5Y bonds. (My previous note goes into more detail about pricing; the idea would be to offer Tax Credits whose present value corresponds with the surrendered bond par). Italy is running a primary surplus of around 1% of GDP – which, with debt of say 120% of GDP, suggests that paying average interest of 0.8% would mean the government would only need funding for bond repayment. While a yield of 80 basis points is probably ambitious, issuing Tax Credits holds out hope of reducing interest costs towards this breakeven level.

By staggering supply, the government could allow the price of Tax Credits to be bid higher as bondholders compete to exchange bonds for risk-free instruments. The higher the price of Tax Credits, the greater the saving for the sovereign. But by offering present value up to the bond par, this is achieved without imposing a haircut on bondholders, and without resorting to coercion or default. In this way, the sovereign sends a credible signal that it intends to honour its promises, which should encourage bonds to trade back up towards par. Conventional borrowing (bond issuance) would then fall back to affordable levels. (Returning to conventional bond issuance at some stage is desirable as it imposes greater discipline.)

Even with this level of generosity to bondholders (certainly in comparison to market prices), the sovereign would save itself a potentially considerable amount of interest over coming years – and also has the opportunity of postponing refinancing needs too. These two factors mean government – not bond vigilantes – can set the terms of necessary austerity. Restoring financial and economic health is not a given with such an emergency scheme – but by greatly boosting domestic liquidity and investor confidence while reducing interest costs, at least recovery would be back within governments’ sights.

*I use quotation marks in order to set aside wider questions of value and purchasing power, since these important ideas are not necessary in de-escalating the current crisis.

** Also available in the FT Long Room and at


Dear Mario (A Plan for Italy)

November 15, 2011

The nemesis of any nation’s public finances is the moment investors demand risk premia correspondent with fears of bond default. To go from this inflexion point to an actual credit event can be rapid, a matter of weeks or even days – not least because the shift upwards in perceptions of risk actually heightens risk i.e. excessive fears become self-fulfilling.

In such circumstances it is imperative to identify and deploy a “circuit-breaker” as soon as possible, a task that has proved extraordinarily difficult to achieve for distressed eurozone sovereigns, whose credibility is constrained, after all. In this post I outline just such a circuit-breaker.

So what can be done? Leaving aside the host of official eurozone proposals being bandied about, what options short of default can distressed sovereigns really enact themselves that would relieve the funding pressures arising from unaffordable risk premia?

Unlike other borrowers, sovereigns can raise taxes from their citizens. Of course this power does not exclude sovereigns from being viewed as risky; however, the obligation to pay tax does mean that an instrument created for the express purpose of meeting this obligation would, to the holder at least, bear zero credit risk. In normal circumstances, this instrument is money: in the eurozone, euros. However, eurozone sovereigns cannot issue euros, part of the reason they are hard to come by in certain markets. But eurozone sovereigns are not prohibited from issuing alternative instruments that they will accept in settlement of taxes levied on their populations.

In present circumstances, issuing Tax Credits may be the least worst if not the last available method for weak eurozone countries to manage their debt and access funding – two vital pillars in any austerity programme. Moreover, a Tax Credit being another name for currency, such a scheme would in effect promote much-needed monetary easing, helping to restore the economic activity on which austerity depends, namely investment.

To meet these objectives, distressed sovereigns have to infuse Tax Credits with credibility. Whereas convincing investors to hold its IOUs means Italy has to offer unaffordable rates of interest, convincing them to hold a Tax Credit that can be used to redeem future tax obligations ought not to come at such a heavy price. This is because unlike for the government bond, the value of a Tax Credit does not rely on the government meeting an increasingly unaffordable obligation; it relies on the government continuing to levy taxes, which (along with death) is unlikely to end any time soon.

What should investors be willing to concede to the sovereign in exchange for Italian Tax Credits, I wonder? Judging by the risk premia being charged, one answer is surely Italian government bonds.

The difference between the risk premium charged on new Italian government bonds (currently around 7%) and that on Tax Credits (a truly risk-free rate) represents a net saving for the sovereign extracted without coercion. The circa EUR2 trillion question is how to exploit this saving (but no more) in order to achieve the goals of sound public finances and economic growth. Fine-tuning the terms of the debt exchange should be about alleviating the debt ‘stock’ and funding ‘flow’ pressures on the sovereign, while minimising the fallout for investors, many of whom, after all, are domestic savers (pension funds, retail investors) and financial institutions critical for the nation’s revival. Even foreign investors, many comprising important elements in the eurozone financial system, may go on to provide vital funding in the future, provided they are treated fairly.

So to the details. In the case of Italy, the treasury would, in exchange for cancelling surrendered government bonds due in t years, offer Tax Credits exercisable in year t + n. (Tax Credits exercisable per year would be limited, say to [50]% of current collections, to ensure a minimum cash collection for non-debt service expenditures.) The exchange rate (r) offered by the treasury would represent the future value of the Tax Credit divided by the bond notional.

Subject to its terms, the scheme would boost Italy’s liquidity position i.e. its ability to run a budget surplus over the short term. However, liquidity comes at a cost for investors, who will therefore expect to be compensated at a risk-free rate of interest i over the corresponding term in return. As Tax Credits are not interest-bearing, i is implicit in r. That is, in quantifying the terms of the exchange (it is voluntary), investors will discount the future value of the Tax Credit (realised in t + n years) at a rate of interest i – using as a proxy some other benchmark such as the deposit rate at the central bank or yields on German government bonds with similar maturities – or maybe even domestic inflation.

In the case of Italy, with most of its public sector debt held by its own citizens, there is immediate scope to implement such a scheme (although foreign ownership is by no means incompatible with the basic premise as trading would repatriate most bonds). Italy, keen to preserve its status as a performing debtor rather than join the club of bailed-out states, will (unlike Greece, in a more perilous position) seek to avoid passing on economic loss to bondholders. This would be achieved by sizing r = (1 + i) ^ (t + n) for any bond being surrendered.

In discussion with investors, the treasury would have to select its own risk-free benchmark. If i = 1%, then for bonds surrendered with 5 years remaining Italy would offer Tax Credits exercisable in 5 + n years. With n = 5, the Tax Credits would be worth 110% of par. With a longer lag (say 10 years), r would rise to 116%. Yet despite no haircut, there is considerable saving for Italy owing to the difference in compounded risk premia over the period t + n. For a bond costing Italy 5% p.a., this amounts to a saving roughly of:

(1 + (5% – i)) ^ t during the term of the bond and the present value of (1 + (7% – i)) ^ n pending exercise of the Tax Credit (assuming bond yields stay around 7%).

This scheme could be offered immediately and should attract interest on all but the most short-dated bonds (of which bondholders might reasonably expect full repayment). For investors, counterparty risk is removed and there is no writedown of their investments. For the sovereign, cumulative debt service costs are slashed while some austerity is postponed, freeing up cash flow without undermining credibility.

Dear Mario, with such a scheme, Italy would have a reprieve – and the breathing space to commence on its programme of reforms as well as introducing some targeted growth-driven spending. There is a double saving: just as the break-even rate of growth necessary to restore sustainable debt dynamics would fall in line with funding costs, the prospects of securing this growth would also improve, both from the lightening of the fiscal adjustment and a de facto monetary loosening. Moreover the Italian yield curve would fall as bonds on all maturities trade up towards par, with investors heartened by having a concrete and credible exit in sight – and all without a cent of official support or ECB intervention!

Finally and crucially, the scheme acts as a circuit-breaker – more bullish investors might retain bonds in the hope of improved circumstances, whereas the more bearish would gladly surrender theirs. The composition of its investor base would migrate towards the more committed and away from speculators. Instead of escalating the crisis, periods of weakening investor sentiment (and there will doubtless be bumps along the way!) would give the sovereign more flexibility, not less as experienced presently.

Austerity, vital to reverse the deterioration in public finances, is not achieved by keeping productive resources idle – on the contrary, this is inexcusable waste. The scheme, unique among the raft of proposals for allowing for a controlled pro-growth stimulus within the confines of the single currency union, must be considered urgently if Italy – and indeed others – are to survive socially, politically and economically intact.

From a friend of Italy