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Safeguarding the European bond market

06744 CC Trader Talk V2

The completion of Greece’s financial rescue programme this summer has been highly regarded by many policymakers as the end of the Eurozone crisis. However, the current confrontation between the European Commission and Italy over fiscal rules has clearly demonstrated that the Eurozone is still exposed to further bond market breakdowns.

Despite numerous Eurozone institutional reforms, such as the establishment of the European Stability Mechanism (ESM), which was set up as an international financial institution by the EU Member States to assist European countries in severe financial distress, the presence of major deficiencies within the European bond market persist. The level of Sovereign debt across European counties is still at a strong level.

The recent implementation of unconventional monetary policies by the European Central Bank (ECB), at least within the shorter-term, have proven to provide a sufficient degree of protection against market turbulence. Nevertheless, as the re-occurrence of such unconventional measures seem to be unlikely, together with normalisation of monetary policy, further bond market dislocations in the Eurozone, await. Without the ECB’s intervention, financial stress could easily lead to additional nasty turmoil within the European bond market, hence negatively impeding the economy.

In this regard, ongoing discussions on how to construct robust procedures against the occurrence of additional shocks are currently underway. Several ideas, such as creating new classes of government bonds through which risk is shared amongst countries, have been suggested. However, the latter have not resulted in any form of rectification. ‘Creditor’ nations have not demonstrated any form of willingness to accept additional debt mutualisation. Similarly, ‘debtor’ nations were also unwilling towards the possibility of being subjected to reform and austerity programmes.

One particular measure which has the capability of preventing and mitigating bond market dislocations, is the creation of a European bond insurance scheme. The adoption of sovereign insurance avoids the political burden of debt mutualisation and austerity regimes, encourages private sector lending while simultaneously reducing the contagion between sovereign debtors. All in all, the concept of a European bond insurance scheme avoids the majority of problems that are encountered through the implementation of alternative rescue tools.

By way of illustration, it would be ideal that such scheme will be implemented as part of the rescue measures of the ESM. In such respect, the potential of the ESM to assist financially distressed countries would be greatly enhanced as the concept embedded within such scheme offers a partial guarantee for eligible sovereign bonds while ensuring that private investors are not negatively affected throughout uncertain market situations. In order for a particular country to make use of such guarantee, pre-determined fees aligned according to the rating of a country and essential factors such as fiscal deficits or debt, would need to be paid.

The fact that the insurance fee reflect both the rating of the country and the progress it has made on its public finances, is deemed as beneficial to all parties involved. The latter creates an encouraging incentive, whereby countries who improve their rating or structural reforms, incur a lower insurance fee.

This insurance scheme has been successfully implemented throughout the recent banking crisis and was also applied to restructure Greek debt instruments after the insolvency of 2012. Likewise, there should be no reason not to use the same strategy in relation to sovereign borrowers.

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