Revue Banque: Economic governance must encourage the safe asset

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Article published by Revue Banque in December 2021 - Supplement to n°862
By Michala MARCUSSEN, Group Chief Economist

A collateral opportunity for European safe assets

A genuine euro area safe asset, affording safe financing to member state governments, would strengthen integration of the euro area, but despite the many proposals made, the political hurdles for such an asset to become a reality remain very high. The ongoing economic governance review offers opportunity to deliver a more credible set of fiscal rules, but while sound public finances would go a long way in securing the safety of national government bonds, the ECB also plays a central role in defining safe assets through its collateral rules. Already, the ECB is due to add a climate dimension to the private asset collateral rules as part of its new monetary policy strategy. The economic governance review also gives the central bank an opportunity to review its collateral rules for public assets and support the safety of euro area government bonds.

Talk of a euro area safe asset has taken something of a back seat in the Covid19 crisis, with sovereign spreads well contained, thanks to the ECB’s Pandemic Emergency Purchase Programme (PEPP) and important fiscal measures taken at the European level; not least the €750bn  Next Generation EU (NGEU) recovery plan. The triggering of the general escape clause of the Stability and Growth Pact, along with an easing of state aide rules, furthermore afforded governments full flexibility to respond to the Covid19 crisis with fiscal stimulus at the national level. The NGEU measures are now being rolled out and the application of the general escape clause continues in 2022, albeit due to be lifted in 2023. The prospect of trimming back the PEPP in 2022 could nonetheless bring wobbles to sovereign spreads, and not least if economic recovery is threatened by high inflation and the ongoing economic governance review falls short. The safe asset debate could thus soon return.

The case for a safe asset remains

Although the measures adopted at the European level in response to the Covid19 crisis were largely temporary, these offered a combined potential increase of €1.4tn for European Commission and ESM debt issuance if measures were drawn in full. The politically important point is that this crisis marked the first time that the EU was allowed to borrow to finance budget expenditures. And despite the temporary design, the financial market perception is clearly that if faced with another similar common shock, similar European level measures would again be taken.

While adding to the stock of triple-A rated assets in the euro area, new debt issuance from the EU and ESM is still a long way from the single safe asset that Europe needs to support Banking Union, Capital Markets Union and the international role of the euro. Setting aside considerations on outstanding issuance size, reality is that if the EU/ESM issuance were to assume the role of a genuine safe asset with preferential treatment over national sovereign bonds, be it on bank balance sheets, balance sheets of regulated investors or in ECB operations, then this could work to the contrary, and increase the risk premia on peripheral debt. 

A genuine safe asset requires that national governments maintain access to safe financing. Ensuring this only for the share of national financing needs that falls within the limits set by the common fiscal rules would have the added benefit of preventing moral hazard. Numerous proposals have been put forward, but be it E-bonds, Red-Blue bonds, Purple bonds or Sovereign Bond-Backed Securities, to name but a few, none have yet to overcome the high political hurdles faced. The on-going economic governance review could nonetheless mark a step forward, and not least if accompanied by a rethink of ECB collateral rules.

Fiscal rules have so far failed to deliver

Going back to the 1992 Maastricht Treaty, sound public finances were framed by a maximum deficit of 3% of GDP and public debt of 60% of GDP. This logic came with two implicit ideas. Back in 1992, average debt of the “core” countries stood at around 60% of GDP; implicit to the 3% debt stabilising deficit ratio was a nominal growth assumption of 5%. The second implicit idea was that any member state exceeding these ratios would be sanctioned by the financial market with a widening sovereign bond yields.

As history has shown, however, both implicit assumptions failed. Growth disappointed, averaging just 3% in nominal terms since the introduction of the euro in 1999. The disciplining forces of the financial markets, moreover, proved largely absent in good times and excessive in bad times. On a final note, the sanctions foreseen in the Stability and Growth Pact (SGP) for failure to comply, proved difficult to operate in practice and the SGP has become increasingly complex over time.

These issues were well recognised by member states prior even to the Covid crisis, and hope is that the ongoing economic governance review will deliver more credible fiscal rules, addressing the issues set out by the European Commission in the October 19, 2021 document, “The EU economy after Covid19: implications for economic governance” and the good news is that there is no shortage of proposals to choose from. Hope is that the new fiscal rules as a minimum will recognised the lower trend growth rate of the euro area and the need for public investment to secure the green and digital transitions. While not delivering a safe asset per se, credible rules could do much to improve the safety of national sovereign bonds.

Collateral rules matter

In pondering the new fiscal rules, it is worth also considering the role that the ECB might play. Indeed, while sound public finances go a long way to securing the safety of national government bonds, central banks also play a central role in defining safe assets through the rules set on collateral accepted and haircuts applied for the various credit facility operations.

The central importance of collateral rules featured clearly in the ECB’s new monetary policy strategy, which promises to include climate disclosures as an eligibility requirement for private assets in the collateral framework and the ECB’s own asset purchases, mirroring the rollout of EU climate disclosure regulation. 2022 should see further details presented, which may also include climate change risk in credit ratings for collateral and asset purchases. It is worth note in this context that 2022 will also see supervisory climate stress tests of individual banks under the supervision of the ECB; the specific design of such tests can also influence the pricing of collateral and here too, at least for now, the scope is private assets.

Turning to public assets, the ECB collateral rules undoubtedly shape market behaviour and concern is that the current framework may add procyclicality to the market discipline channel through two main channels. First, the ECB framework relies on a first best rule, taking the best available external credit assessment institution from a set list. Such sovereign ratings tend by design to be pro-cyclical. Second, the ECB framework comes with quite large credit quality haircut steps when an issue moves from one collateral category to the next. Markets will be mindful hereof when an issue rating moves close to the category threshold.

While any central bank undeniably needs sound collateral rules to protects its own balance sheets, and ultimately also taxpayers, it should also be careful not to unwarrantedly undermine the safe asset status of its sovereign(s) bonds. To be fair, the ECB has in times of crisis demonstrated flexibility, easing collateral rules and fighting unwarranted widening of sovereign spreads, not least with the introduction of Outright Monetary Transactions (OMT) in 2012, following Mario Draghi’s famous “whatever it takes” speech, and later on with large scale public purchases. The introduction of the Pandemic Emergency Purchase Programme (PEPP) in response to the Covid19 crisis was welcomed by many as another “whatever it takes” moment. It’s worth note, moreover, that the asset purchases have been financed by issuance of the safest asset, namely central bank reserves.

The review of the fiscal rules may nonetheless pave the way for the ECB to rethink its collateral rules, for example linking these at least in part to the fiscal rules of the governance framework and adjusting the haircut scale as proposed by Gregory Claes and Ines Goncalves Raposo in the 2018 Bruegel post, “Is the ECB Collateral framework compromising the safe-asset status of euro area sovereign bonds?”

Given the potential risk of the ECB becoming politicised, it is not hard to understand the attraction of drawing on external credit rating agencies. At the same time, drawing on the expertise of the ESM, as proposed by Claes and Goncalves Raposo, and not least linking this to the new set of fiscal rules and perhaps even climate criteria, could go a long way to underpinning the safety of national sovereign bonds as the long wait for a genuine single safe asset continues.

Group Chief Economist