12th IMF Forum on Managing Sovereign Risk and Public Debt: “Managing Sovereign Debt: A Seismic Shift in Demand and Supply Dynamics?”

Opening Remarks by Min Zhu, Deputy Managing Director, International Monetary Fund
Rio de Janeiro, Brazil, June 28–29, 2012

A. Introduction

Good morning. I am delighted to be here. Let me start by thanking the Brazilian authorities for hosting our annual round of discussions on sovereign risk and debt capital market issues. In particular, I would like to thank Marcio Holland and his team for organizing this great event. Brazil remains at the forefront of the debate over the complex aspects of debt strategy, debt management, and deepening of local debt markets. And it is a true privilege to have among us today the Brazilian colleagues who carry all that knowledge and expertise.

This forum offers a great opportunity to discuss in depth some of the main challenges of public debt management during periods of market stress and cyclical weaknesses. I hope these discussions will help debt managers to develop a common understanding of the crucial issues. This, in turn, could help eventually reduce sovereign vulnerabilities and restore stability in debt capital markets.

Clearly, we have reached a critical juncture. The financial crisis has deeply affected market confidence and financial stability, and continues to weigh on the economic recovery in Europe and beyond. Some European sovereigns face the unenviable task of supporting their weakened financial systems, at a time when markets are increasingly worried about the impact that this will have on public debt sustainability. No one can afford to ignore this adverse feedback loop and its potential spillovers to the rest of the world. The IMF and its multilateral/bilateral partners have been keeping a close eye on these major challenges. Given that the potential for a global downturn remains sizable, we have continued to stress the importance of coordinated and bold action in contrast to the approach that has often been characterized as “too little, too late.”

All in all, developments over the past few years suggest that we might be experiencing a seismic shift in the environment in which policymakers—particularly debt managers and central bankers—operate.

B. Market Access in the Current Environment

I will begin by laying out some of the stylized facts that may be relevant for our discussion:

1. First, sovereign bond spreads in some euro area countries have gone far beyond their 2008-09 levels. Indeed, pricing of options on Euro area assets are beginning to reflect important concerns about tail risk.

2. Second, the traditional investor base is shifting due to rising demand for safety among international investors, growing concerns about sovereign credit risk, increased purchases by domestic banks of bonds issued by their sovereigns, and a greater debt market involvement by central banks in core European countries.

3. Third, the challenges posed by the limitations of traditional support mechanisms based on official assistance, as shown by the recent experience of the Spanish banking system. A case in point is the growing concern about the subordination of private creditor claims.

4. Fourth, there is continuing uncertainty over the impact of proposed financial regulations, including the Volcker rule and some key aspects of Basel III.

While it is easy to draw up such lists, we have yet to fully comprehend the interplay of factors driving sovereign risk. The nature of sovereign risk has been transformed in a number of ways since the beginning of the financial crisis four years ago.

Conventional view

There is no doubt that high levels of debt and fiscal vulnerabilities play key roles in market assessments of sovereign risk. As we have noted on many occasions, these vulnerabilities in advanced economies—if left unaddressed—can undermine the economic recovery and jeopardize financial stability. Yet, while the hardest-hit economies have implemented painful deficit reduction measures, they continue to face substantially increased sovereign bond spreads. We have also seen major sovereign downgrades, increased volatility in government debt markets, and continued stresses in many sovereign funding markets.

New challenges

Obviously, elevated government debt levels are not the only factors driving the pricing of sovereign securities. It is fair to assume that—at least in the European context—contingent risk associated with the financial sector is playing an important role. When the public sector has intervened to support financial institutions, distinctions between sovereign and private liabilities were blurred and public exposure to private risks has since increased.

Because of the interconnectedness of sovereigns and banks, it is essential to assess the interplay of their respective vulnerabilities. In this regard, I am pleased that we will be able to share with you later today our preliminary sovereign stress testing principles and general framework—promised to you in Seoul last year—which explicitly incorporate these linkages.

Debt managers are seeking to cope with these linkages, which have become key risks to financial stability. They also face several other challenges:

1. One is financial stability. This crisis has showed us that the propensity for sovereign funding-related concerns to spill over into the financial sector can be rather high. (The opposite, of course, remains true as well).

2. Another is supply of safe assets. The unconditional reliance on availability of at least one asset per country that provides guarantees for the purchasing power of the original principal is being challenged in practice. In fact, the supply of supposedly safe assets has continued to shrink, despite the crisis-induced increase in demand for such assets.

3. Lastly, there is the need to develop an Asset and Liability Management framework, which would adopt a consolidated view of the sovereign balance sheet across various public institutions to increase resilience to external shocks and mitigate risks.

On some of these issues, the IMF is providing assistance to the debt management community. For example, we are in the process of arranging funding for a new Sustainable Debt Strategies Topical Trust Fund, to be launched in 2013. This fund—aimed at low- and middle-income countries—would help increase their analytical capacity to assess, monitor, and manage risks associated with public debt.

C. The Role of Policy in Debt Market Outcomes

The most important short-term issue facing debt managers is the need to restore market confidence in those European economies that are facing the greatest pressures. Confidence is unlikely to be restored so long as the underlying causes of the crisis remain unaddressed. In this regard, conventional policies have an important role to play.

Fiscal policy

First, credible fiscal adjustment efforts are needed to contain market volatility and put the economies back on the path to recovery. This requires a medium-term fiscal framework, including safeguards against potential policy U-turns. Of course, excessive near-term fiscal tightening could stifle the nascent recovery, and it is a risk that must be balanced against the one associated with a debt crisis-related downturn. Finding the right balance depends on country-specific circumstances.

Second, the long-term health of the euro area will depend on the emergence of some form of common fiscal policy. Introduction of a limited form of common debt, with appropriate governance safeguards, can provide an intermediate step towards fiscal integration and risk sharing as well as help break the sovereign-financial nexus. Such debt securities could, at first, be restricted to shorter maturities and small size and be conditional on more centralized control. Financing via such common securities could, for example, be used to provide the backstop for the common frameworks within the banking union.
Third, using public funds to recapitalize banks may be the only viable option in some cases, but it tends to come at a price—a further rise in sovereign bond yields driven by concerns about fiscal sustainability. Again, this feedback loop must be broken through credible fiscal adjustments and adequate backstops.

Monetary policy

Unlike fiscal policy, monetary policy in many advanced economies has remained extraordinarily accommodative. For example, euro area banks have received unprecedented liquidity support though the ECB’s long-term refinancing operations (LTROs).

While monetary policy cannot provide a lasting solution to the underlying crisis, the ECB has some room to ease policy rates and signal a commitment to a more accommodative stance for a prolonged period. The ECB also needs to ensure that its monetary support is effective and continue to provide ample liquidity support to banks under sufficiently flexible conditions.

However, while the LTROs were effective in the short term, they did not address some other pressures—notably de-leveraging by European banks. The extent of deleveraging is now fairly consistent with the weak policies scenario presented in our April 2012 Global Financial Stability Report. At the time, we estimated that large European Union banks could shed a total of US$3.8 trillion, or 10 percent, of their total assets by the end of 2013. This retrenchment could reduce euro area credit supply by 4.4 percent; and GDP could fall by 1.4 percent from the WEO baseline after two years.

Debt Management and Debt Restructuring

The nature of this continuing crisis means that debt managers will have to remain squarely focused on sovereign balance sheet risks. In countries facing market pressures, debt managers must choose strategies that lengthen the maturity profile of sovereign debt and further diversify the investor base. This may be easier said than done but in light of the current challenges—and consistent with the principles adopted in Stockholm two years ago—debt managers should aim to minimize execution risk and deploy a range of liability management operations to help reduce market volatility and support secondary market liquidity.

The recent experience in Greece has underscored the need for a better understanding of the tradeoffs involved in the timing and design of a sovereign debt restructuring. I am glad that we will have a session devoted to the lessons learned. In this regard, we can all benefit from the experience of emerging economies in the past two decades. A recent IMF paper captures some of the main points:

  • First, despite lengthy negotiations and delays in many debt restructurings, creditor coordination and holdouts have not generally been a major problem. And participation rates have often exceeded 90 percent, even among dispersed bondholders.
  • Second, macroeconomic indicators tended to improve in the immediate years after debt restructurings.
  • Third, while being restored relatively quickly, post restructuring market access often comes at a cost of higher spreads. Not surprisingly, greater haircuts were associated with larger post-restructuring bond spreads, with the effect decreasing over time.
  • And fourth, in some cases, restructurings were associated with spillovers into the financial sector, emphasizing the importance of an effective backstop to minimize this impact.

D. Conclusion

To conclude, strengthening the sovereign balance sheets of advanced economies—especially in the euro area—is a precondition for global financial stability and continued economic recovery. Debt managers will play a crucial role in achieving these goals, and our roundtable discussions will focus on some of the main challenges and opportunities of debt management. We look forward to receiving your ideas, comments, and suggestions, including on the IMF’s role in this process.

Thank you.


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