ECB should take a leaf out of RBI’s books
How can Italy’s problem be solved? One way is to move out of the Euro and make the debt denominated in Lira (Italian currency before the Euro). By doing this Italy can print money to repay bondholders. Italy and the EU (European Union) do not want this (Italy moving out of the Euro). The other way is to make the ECB more proactive and accountable for Italian debt. ECB should manage Italy’s debt and by doing so will calm investors as ECB managing Italy’s debt is better than Italy managing Italy’s debt. The second way already exists in India, and the ECB should learn from the RBI on how to go about managing Italy’s debt.
The RBI apart from managing the central government debt also manages the state government debt. India has 28 states and RBI manages the borrowing for the states. Each state has its own budget and financial position differ from state to state. State government bonds (called SDL or state development loans) carry credit risk. States cannot print money to repay bondholders unlike the central government. However despite some state having weak financials, the borrowing costs for states do not shoot up in relation to central government borrowing costs. Ten year SDL trade at spreads of around 30bps over ten year government bonds. This spread has consistently been in a 30bps to 60bps over the last few years.
Chart 1. Italian ten year bond yields
The investors in SDL ‘s include provident and pension funds, banks and insurance companies. Banks do not have a compulsion to invest in SDL’s but they do invest in SDL’s as it fetches them higher yields than government bonds and they have the comfort of RBI managing the borrowing. SDL auctions rarely go unsubscribed.
The RBI in managing state government borrowing, makes sure that each state services its debt by placing money in an escrow account, just before the interest or principal is due. There is not a single case of a state defaulting on its debt as the RBI is actively involved in making sure states service their debt. The RBI closely interacts with the finance secretaries of each state to make sure states do not go overboard in borrowing and that budgets are more or less balanced.
The ECB by following the RBI will manage Italy’s borrowing and make sure Italy services its debt by placing money in an escrow account to fund its interest and principle. The ECB can provide temporary overdraft to Italy to tide over any problems in placing money in the escrow. The ECB can also interact with the Italian finance minister on Italy’s borrowing and budget deficit to make sure Italy does not go overboard in its finances.
The ECB should treat Germany as the central government and all other member nations as state governments. Germany should also play its part in being the strongest country of the Eurozone by acting as a mentor and helping out troubled nations. The ECB will then make sure the nations get back on track and German taxpayers money is safe.
The ECB managing Eurozone debt will bring down the German-other country debt spreads. The spreads for Italian debt to German debt are 500bps as opposed to a SDL with central government debt at 30bps. Italian bond spreads will come off sharply once ECB gets into the picture.
The centre of Eurozone debt issue is that sovereign nations who have adopted the single currency are actually funding sovereign debt through external borrowing. For example Italy, which requires to borrow from the markets to service its large debt (USD 2.2 trillion), borrows in Euros. Investors in Italian bonds are not only Italian banks but also banks from other European and non European countries. Eurozone investors take the credit risk of Italy in buying Italian bonds while non Eurozone investors take the credit risk of Italy and the currency risk of the seventeen nation currency.
Chart 2. Italy-German ten year bond spreads
The central bank of Italy is the ECB (European Central Bank). If Italy is facing pressure on refinancing its debt, the ECB cannot help Italy by either buying its bonds or by giving the country overdraft to stem temporary liquidity problems. Hence to Italy, ECB is ineffective, as it cannot help Italy in its debt problems, which may well be temporary. Italy also has an issue of demand for its bonds. Non Italian borrowers have no compulsion to invest in Italian bonds and in troubled times such borrowers will vanish, leaving a large demand supply gap. This demand supply gap pushes up yields on Italian bonds as seen in the last week, where bond yields crossed 7% levels.
The new ECB president Mario Draghi started off with a bang by cutting policy rates and he can now act to save the Euro by taking on the task of managing Eurozone debt, not by buying its bonds but by making sure each government acts responsibly. RBI is doing it with 28 states, ECB can definitely manage with seventeen countries.
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