Working Paper: CEPR ID: DP5387
Authors: Willem H. Buiter; Anne Sibert
Abstract: Market interest rates on sovereign debt issued by the 12 Eurozone national governments differ very little from each other, despite the credit ratings of these governments ranging from triple A to single A, and despite significant differences among their objective indicators of fiscal-financial sustainability. We argue that this market failure is at least in part due to a policy failure: the operational practices of the European Central Bank and the rest of the Eurosystem in its collateralised open market operations convey the message that the Eurosystem views the debt of the 12 Eurozone sovereigns as equivalent. The euro-denominated debt instruments of all twelve Eurozone governments are deemed to be eligible for use as collateral in collateralised lending by the Eurosystem. They are in addition allocated to the same (highest) liquidity category (Tier One, Category 1) as the debt instruments of the Eurosystem itself and subject to the lowest 'valuation haircut' (discount on the market value). Haircuts also increase with the remaining time to maturity. This discourages the use as collateral of longer maturity debt which would be more likely to reveal differences in sovereign default risk. We propose that the size of the haircut on each debt instrument be related inversely to its credit rating. A further re-enforcement of the market?s ability to penalise and constrain unsustainable budgetary policies would be to declare the sovereign debt of nations that violate the conditions of the Stability and Growth Pact to be ineligible as collateral in Eurosystem Repos.
Keywords: collateralised loans; Eurosystem; sovereign default risk
JEL Codes: E58; E63; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Eurosystem's treatment of collateral in open market operations (E52) | suppression of differences in sovereign default risk premia among eurozone countries (F36) |
| uniform treatment of sovereign debt as equivalent (F34) | misleading signal that all debts are similarly low-risk (G33) |
| haircuts applied to collateralized loans do not reflect actual risk of sovereign default (F34) | mispricing of risk in the market (G19) |
| market does not impose larger default risk premium differentials despite significant differences in fiscal sustainability (G19) | part of the sovereign risk puzzle (F34) |
| adjusting the haircuts inversely to credit ratings (G21) | reinforce market discipline and improve fiscal accountability among eurozone nations (E62) |