The Post-Eurocrisis Two-Speed Europe - Core and Periphery

" 60 years of European integration without war is an historical anomaly of which the old continent can be proud of", enthused Hans Magnus Enzensberger once.  Today by contrast, the desperate and so far unsuccessful search for a solution to the Eurozone crisis would suggest that Europe has lost vision. Only 42% of the EU population trusts the European institutions and only 49% think that EU membership brings advantages to their country. As Mancur Olson has stated in his seminal The Logic of Collective Action (1965), bureaucratic inefficiency (in public choice terminology: agency slippage) is likely to rise with the number of member states; the principals (the member countries) have less incentives to closely monitor the agent (here, the EU bureaucracy) as the return from control for each member shrinks with the rise of the number of members. This insight applies, to be sure, not to the EU alone; think OECD...

Michael Hüther, director of the business-funded German economic policy instute - Institut der deutschen Wirtschaft - has an excellent essay in the widely noted Forum page of the leading left-liberal German daily Süddeutsche Zeitung. (An English version is not yet available, it seems.)  Europe's problem to come to grips with the sovereign Euro debt crisis, which risks an implosion of the Eurozone, is not only rooted in wrong institutional settings (such as the failed Maastricht treaty) and government responses, according to Hüther. Today, Europe lacks direction, a narrative where to go. So it can't, for example, opt for Eurobonds, or support an ECB that acts as an unlimited bond buyer of last resort.

In the past, European unification had been initiated by a postwar-generation elite that was driven by Christian neo-humanistic ideals anchored in the early medieval Western Europe of Charlemagne. As emphasised by the historian Hans-Ulrich Wehler, Romantic and Gothic, Renaissance and Humanism, Baroque and Enlightenment are European phenomena. Secterian wars (Konfessionskriege) triggered state building and a common civilisation in Europe, in particular after the Westphalian Peace of 1648, by following two maxims: peace through order of law, and peace through the secularisation of the polity.

The megalomania of politicians which led to boulimic EU enlargement has overstretched the common cultural background and sense of belonging on which further important, but critically difficult policies towards a strengtheneing of the Eurozone can be based. Theories (Mundell, 1961; McKinnon, 1963; Kenen, 1969) of the Optimal Currency Area stressed - apart from fiscal federalism and labour mobility - a common attitude toward macroeconomic trade-offs such as fiscal discipline, price stability and employment.

A strengthening of core Europe is needed, according to Hüther, if the EU wants avoid marginalisation by the G2, the US and China. That strengthening of core Europe should not just be based on similar attitudes toward macroeconomic stability and honest statistics (witness how Italy and Greece 'beat' the Maastricht criteria), but reach into common cultural history(for more, read the political theorist Herfried Münkler). Core Europe does not exclude intense collaboration with Europe's periphery, to the contrary. Only a two-speed Europe will be politically able to go for Eurobonds that will finance, for example, pan-European infrastructure. Only a solid core Europe will avoid rating and speculative 'attacks' from Anglosaxon finance. And that core Europe, the net contributor to the European project, will call the shots.

Addition (3rd August 2011); If the market is to be trusted, that core Europe will exclude Italy and Spain and hold a very limited number of countries...Would Brussels still be the capital, given Belguim's spreads?

Is China a White Knight for the Eurozone?

China has been concerned about the value of the US dollar since the U.S. Federal Reserve adopted a loose monetary policy in the wake of the financial crisis. At end April this year, China’s FX reserves stood at US$ 3.2 trn. But while in the past China’s US dollar acquisitions and FX reserves grew in tandem,  the US dollar share of China’s bond purchases has come down considerably. According to research at Standard Chartered, the difference between China’s new FX reserves and its purchases of US assets has grown to a record gap of $ 150bn this year, or 76 per cent of China’s total 2011 FX reserve additions (up to end April). China is buying something else. Something non-American.

Euro assets are the only other sizable diversification from the US dollar available to China for its burgeoning forex reserves. The Economist recently quoted BNY Mellon estimates that around a quarter of China’s reserves are now in euro-denominated assets. Given the recent pace of accumulation—around $200 billion a quarter—that would suggest that $ 150 billion-200 billion of Chinese reserves have found their way to the euro zone since last summer. The Chinese may have been buying as much sovereign debt from struggling states as the European Central Bank (ECB) has. China is interested in AAA European debt issued through the European Financial Stability Facility (EFSF), according to statements from the EFSF CEO Klaus Regling. AAA-rated debt yields higher for Euro than for US dollar assets – part of the attraction apart from diversification motives. Last week’s decision by EU leaders to back European peripheral credit with ‘Eurobonds’ will lead to deeper, more liquid bond markets in Europe. For Asian investors who look for deep bond markets to invest in, this should provide further reason to divest from the US into Europe.

China invests excess savings not just in liquid debt instruments, but also in equity assets, for example through sovereign wealth funds. Adding up China’s five (!) sovereign wealth funds (SAFE Investment Company; China Investment Corporation; Hong Kong Monetary Investment Authority; National Social Security Fund; China-Africa Development Fund), the SWF Institute reports current assets to total US$ 1.34 trn. Private individual and corporate investors take stakes as well, as China wants to diversify away from financial into real assets. The figure above (from The Economist)  shows that although Europe lacks behind Asia, Latin America, and Africa as  host of China’s foreign direct investment stock, the Old Continent reported in 2009 the highest percentage increase of Chinese FDI purchases. China has the reputation to love infrastructure assets. Peripheral Europe will be forced to privatise exactly those state assets that China is keen on.  This is how the Chinese state-owned company Cosco, for example, could buy up the Greek port of Piraeus, with the idea of turning it into a beachhead for Chinese exports into Europe.

China’s self-interest and gradualism (摸着石头过河) stand in the way of a major assistance to solve the Eurozone problem through Chinese capital. The regulatory framework and external competitiveness of Southern Europe are prerequisites for further important inflows from Asia; the massive net asset position that China hold in US dollars militates against abrupt moves out of US dollar assets. But a deeper Eurobond market and the fit of Europe’s saleable public-sector assets with China’s national excess savings provide avenues for policy solutions and Euro support.

Lessons for the Eurozone from Emerging-Market Ratings

German chancellor Angela Merkel called Sunday for the creation of a European credit rating agency, on the back of recent discontent over the downgrading of some EU economies. But you do not destroy a mirror merely because it tells you that you are ugly.

You discard a mirror that is blind and has nourished illusions for too long, however. Rather than to establish yet another rating agency, the appropriate policy response will be a thorough revision, in fact exclusion, of the role of sovereign ratings in prudential regulation and even in internal industry guidelines. That lesson was already brought home in the 1990s and early 2000s when sovereign ratings had intensified emerging market currency crises repeatedly. The 1990s had witnessed pronounced boom–bust cycles in emerging-markets lending, culminating in the Asian financial and currency crisis of 1997–8. In the 1990s already, credit rating agencies were conspicuous among the many who failed to predict the Mexican and Asian currency crises. Having failed to perceive the extent of problems as long as foreign money flowed in, the rating agencies then overreacted by downgrading the affected countries to junk status. While the explanatory power of conventional rating determinants has declined since the Asian crisis (Reisen, 2003), rating performance for Argentina and Turkey in the early 2000s could still be qualified as lagging the markets, as variables of financial-sector strength and the endogenous effects of capital flows on macroeconomic variables seem to remain underemphasised in rating assessments.

Sovereign ratings have been to a large extent explained by a limited number of key macroeconomic variables before the Asian crisis (Cantor and Packer, 1996). Per capita income (+), GDP growth (+), consumer price inflation (-), foreign debt as percentage of exports (-), dummy for economic development (+), dummy for default history (-) are generally significant with the expected sign, while fiscal balance (+) and external balance (+) did not enter significantly the authors’ multiple regression estimates.

In principle, sovereign ratings might be able to help to attenuate boom–bust cycles. During the boom, early rating downgrades would help to dampen euphoric expectations and reduce private short-term capital flows which have repeatedly been seen to fuel credit booms and financial vulnerability in the capital-importing countries. By contrast, if sovereign ratings had no market impact, they would be unable to smooth boom–bust cycles.Worse, if sovereign ratings lag rather than lead financial markets, but have a market impact, improving ratings would reinforce euphoric expectations and stimulate excessive capital inflows during the boom whereas during the bust, downgrading might add to panic among investors, driving money out of the country and sovereign yield spreads up. If guided by outdated crisis models, sovereign ratings would fail to provide early warning signals ahead of a currency crisis, which again might reinforce herd behaviour by investors.

The problem is that credit rating agencies cannot easily acquire superior information on sovereign debt:

·         First, sovereign-risk ratings are primarily based on publicly-available information, such as foreign debt and reserves or political and fiscal constraints. This makes them different from ratings of companies. With companies, credit rating agencies may have access to inside information from domestic corporate borrowers (such as acquisitions, new products and debt issuance plans). Such advance knowledge or better information can then be conveyed to market participants through ratings on private borrowers. This is not the case with sovereign borrowers.

·         Second, in the absence of a credible international mechanism to sanction a sovereign default the premium charged to reflect the risk of default is determined by a borrower's willingness to pay, rather than by his ability to pay. There is also a problem of enforceability: the authorities cannot give an absolute promise that in future they and their successors will put foreign capital to productive use or that future returns will be used to repay foreign debt.

·         Third, rating agencies get most of their revenue from governments to provide a debt rating. Naturally, they are loath to downgrade their clients. This may well introduce 'downgrade rigidity' into ratings especially in periods of large capital inflows.

Research at the OECD Development Centre has established evidence more than a decade ago that emerging-market sovereign credit ratings are reactive rather than preventive (Larrain, Reisen and von Maltzan, 1997).  As a result, they tend to amplify boom-bust cycles in sovereign lending. An event study (Reisen and von Maltzan, 1999), covering 14 sample countries during 1988 and 1997, explored the market response for 30 trading days before and after rating announcements. The study found a significant impact of imminent upgrades (positive outlook) and implemented downgrades for a combination of ratings by the three leading agencies, despite strong anticipation of rating events. Granger causality tests, by correcting for joint determinants of ratings and yield spreads, found that changes in sovereign ratings do not independently lead sovereign bond markets. A recent study by the Inter-American Development Bank (Cavallo, Powell and Rigobon, 2008), covering daily information for 32 emerging countries during 1998 and 2007, confirmed the results that sovereign ratings do impact yield spread above their common macroeconomic determinants. 

Why are ratings so influential? The answer is that herd instinct, reinforced by prudential regulation and internal industry guidelines for institutional investors, give sovereign ratings the power to influence sovereign bond yields. Hence, sovereign ratings absolve banks and money managers willing to hold sovereign bonds from making independent judgments about sovereign risk. The important gap in risk spreads of sub-investment grade (junk) over investment-grade bonds points to a fatal regulatory non-linearity: losing investment grade status means that pension funds, insurers and other institutional investors face internal and prudential guidelines that prohibit them to invest into ‘junk’ bonds. The importance of rating agencies in macroprudential regulation had been reinforced by revisions to the Basel Accord on regulatory bank capital requirements. Moving from risk-insensitive (Basel I) to risk-sensitive (Basel II) capital requirements, the capital buffers banks held in anticipation of cyclical shocks to their earnings were turned to pro-cyclical by the new regulation (Repullo and Suarez, 2008).

So what should be done? The answer is to turn sovereign ratings into proper early warning signals or to drop their role in prudential regulation. Since part of the problem is that rating agencies get much of their revenue from borrowers, the industry will have to reorient its fee structure towards investors. Their dependence on borrowers is incompatible with the incentive to come up with timely negative rating. At the same time, prudential regulators should reconsider the role of sovereign ratings that they stipulate when institutional investors hold sovereign bonds. The removal of investment grading requirements for institutional portfolios might attenuate the boom-bust cycle in bonds pricing. Unless sovereign ratings can be turned into proper early warning systems, they will continue adding to the instability of international capital flows, make returns to investors more volatile than they need be and reduce the benefits of capital markets to recipient countries. Creating yet another rating agency is no solution. The public genesis of a European credit rating agency will make its ratings even more ‘sticky’ than those of the leading agencies.

References

Cantor, R., and F. Packer. 1996. “Determinants and Impact of Sovereign Credit Ratings”, Economic Policy Review 2(2), pp. 37-53. New York, United States: Federal Reserve Bank of New York.

Cavallo, Eduardo A., Andrew Powell and Roberto Rigobón (2008), “Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business Institutions”, Inter-American Development Bank. Research Dept Working Papers, No. 647, November.

Larraín, Guillermo, Helmut Reisen and Julia von Maltzan (1997), „Emerging Market Risk and Sovereign Credit Ratings”, OECD Development Centre Working Paper No.124, April.

Reisen, Helmut and Julia von Maltzan (1999), „Boom and Bust and Sovereign Ratings”, International Finance, Vol. 2.2., pp. 273-93,  July.

Reisen, Helmut (2003), “Sovereign Ratings since the Asian Crisis”, OECD Development Centre Working Paper No. 214, November.

Repullo, Rafael and Javier Suarez (2008), “The Procyclical Effects of Basel II”, CEPR Discussion Paper DP6862, June.