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ECB and the treatment of sovereign debt

ECB and the treatment of sovereign debt

Peter Praet gave an interview to the Financial Times this morning where he made a very important point about sovereign debt holdings (full transcript without the paywall courtesy of the ECB here):

The worst case, to say it very bluntly, is of a central bank providing liquidity to banks just to buy or carry legacy assets, and the banking sector doesn’t restructure. This was typically the Japanese situation in the early 2000s.

Perhaps paradoxically, a rigorous AQR and stress test helps monetary policy. Appropriately treating banks’ holdings of sovereign debt according to the risk that they pose to banks’ capital makes it unlikely that the banks will use central bank liquidity to excessively increase their exposure to sovereign debt. This is because banks will be wary of the constraints placed on sovereign debt by the stress tests to which they are subject at the same time.

The ECB had expressed dissatisfaction about the fact that the previous round of LTRO had been used to buy sovereign bonds and offered banks with an easy carry trade which in turn contributed to increase financial fragmentation and the sovereign-banks nexus as banks hoarded domestic government bonds. This is now described as an unintended consequence that needs to be addressed. This was a critical point made by Jens Weidmann in a recent OpEd in the FT and it is also something that has been at the heart of discussions in the context of the AQR and the ESRB.

easy carry trade

There are two very different problems here that should be distinguished:

The first is the increase in sovereign debt holdings in aggregate and this is hardly an unintended consequences, this was actually precisely the point of the LTRO. Get banks to hold assets because their liquidity risks were taken care of. The LTRO were designed both to stabilize sovereign debt markets and loosen monetary conditions, in that sense they have worked pretty well, driving government funding pressures and affected yields across the credit spectrum.

The second is the concentration of domestic debt, (ie. the renationalisation of debt holdings). This is the real unintended consequence. The ECB probably didn’t anticipated so much national hoarding. But this can easily be controlled by diversification/concentration caps on sovereign debt holdings. This is actually something the ECB could impose as a single supervisor, via the European Systemic Risk Board or in the context of the AQR but this is very different from imposing capital surcharges or haircuts on sovereign debt in repo operations.

sovereign debt holdings


It is critical that the ECB differentiates the problem of large holdings of sovereign debt (quite normal in high risk aversion environment) from high domestic concentration of sovereign debt holdings. These are two different issues. Confusing both will lead the ECB to:

  • tighten monetary condition at the worse possible moment
  • weaken the transmission channels via the refinancing operations of government debt
  • destabilise government debt markets by exacerbating already challenging funding conditions for sovereigns
  • weaken banks’ profitability and increase risks to financial stability
Fiscal devaluation without wage growth will trigger bad side effects both at home and abroad.

Fiscal devaluation without wage growth will trigger bad side effects both at home and abroad.

“Restoring competitiveness via structural reforms,” as the mantra goes, has in practice been a policy not so much geared toward creating productivity gains but rather designed to pursue wage and price reductions to boost exports. When these nominal or real reductions in wages were difficult to secure politically, they were replaced by fiscal devaluations, shifting taxes away from labor toward indirect taxes. It’s a policy that mimics an exchange-rate devaluation by modifying relative prices.

In effect, Europe has replaced the competitive exchange-rate devaluations of the 1970s and 1980s with wage compression and fiscal devaluations within the euro. The result is a policy race to the bottom that spreads deflation inside and outside the euro area. Even a country like Finland, which stands at the top of every competitiveness and ease-of-doing-business indicator, has now convinced itself that the best way to lift itself out of a three-year recession is to restore price competitiveness through a reduction in hourly wages.

The collective effect of this policy weighs heavily on aggregate demand and fuels deflationary forces. It also undermines the European Central Bank’s objective of achieving 2% inflation through low interest rates and purchases of sovereign bonds and other assets.

current-account surplus


The European Commission’s macroeconomic-imbalances procedure, which was established during the crisis to allow the better coordination of national economic policies, has so far been a failure. It has proved ineffective for spotting excessive deficits and impotent in confronting excessive surpluses.

The eurozone needs to address its internal and external imbalances more seriously. This can’t be achieved by fiscal consolidation, structural reforms and devaluations. It has to involve not only fiscal expansion in countries that can afford it most, but also a sustained rise in wages across the euro area to boost domestic demand.

The inability to do so is no longer simply a problem for the euro-zone itself. It’s a matter of global relevance. The eurozone’s current-account surplus is now 3.7% of GDP, the largest in the world in absolute terms, and it’s expected to remain at such elevated levels over the next few years. A possible new round of monetary accommodation by the ECB could increase it even further.

Indeed, a depreciation of the euro would only be expansionary for the whole world if the effects on domestic demand and financial conditions in the euro-zone were greater than the contractionary side-effect of appreciating other currencies in the rest of the world. Yet monetary policy alone, at least in the near term, won’t be able to countervail the demand-suppressing consequences of lower wages and debt deleveraging.


The debate on the degree to which Europe’s policy failure has become a global one hasn’t really started. The International Monetary Fund and the G-20 statements remain too kind and international pressures too limited.

Since the height of the crisis, the matter of global imbalances has receded and international coordination on the matter has declined. The IMF expects the U.S. current-account deficit to have shrunk by nearly half compared to 2007 levels. China’s slow rebalancing has brought the current-account surplus down to 3% of GDP from 10%.

Meanwhile, the U.S. and China seem to have found at least a transitory monetary peace, a pax chimericana: the U.S. government will agree to China’s newly created Asia Infrastructure Investment Bank and entry into the IMF’s special drawing rights basket of currencies, while China will try to maintain a relatively stable currency to prevent another round of rapid appreciation of the dollar.

This policy coordination between the world’s two leading economic powers seems far more developed and effective than what’s happening within the G-20 and surely within the euro-zone. And yet, the case against the eurozone’s macroeconomic policy is unlikely to be made effectively at the forthcoming G-20 summit in Turkey because it is politically charged and directly linked to the dysfunctional governance of the monetary union.

In Europe, there hasn’t been a meaningful discussion on macroeconomics since ECB President Mario Draghi’s Jackson Hole speech last year. The fiscal question remains largely taboo, and the policy consensus is that economic reforms and currency devaluation can somehow kick-start and sustain the recovery. Both the empirical and theoretical evidence suggest the opposite.

economic reforms

The euro-zone and its member states can’t continue to behave as if they were a small, open economy. It’s a mistake for the G-20 to let the eurozone continue to free ride and undermine the increasingly fragile global recovery.

Mr. Vallée, a former adviser to the French economy minister and the president of the European Council, is a senior economist at Soros Fund Management LLC.