A true European safe asset is essential for the development of the capital markets union and savings and investment union. Without it, European capital and financial markets will remain constrained and the internationalisation of the euro will flounder.
Safe assets are defined by their low default risk, robustness to economic volatility and high liquidity. Definitions of ‘low default risk’ often cluster around 0.5% probability of default over a 5-year time horizon. Robustness to economic volatility may be defined in terms of the change in the spread between the 10-year zero-coupon rate and the overnight index swap rate during times of economic volatility. High liquidity means the capacity to transact at volume without substantially impacting market prices.
Currently no true European safe asset
Often, the Bund or the debt of the European supranationals are cited as constituting the stock of European safe assets. However, a true European safe asset needs to be both disconnected from the economic fundamentals of any particular national economy and be homogenous enough to provide fungibility between bonds with roughly equivalent characteristics. With these definitional appendages, neither asset qualifies.
While the ‘E-Supra’ market, comprised of issuance from the European Investment Bank, the European Stability Mechanism, the European Financial Stability Fund and the European Union, is large, with approximately €1.5tn outstanding, it is neither sufficiently liquid nor robust to economic volatility to earn true safe-asset status. Further, it is fragmented between the issuers, with their differing guarantee and liability mechanisms, capital bases and issuance history, making it insufficiently homogenous. The Bund, while homogenous, is tied to the German economy, making it inadequate as a true European safe asset.
This leaves us with a definition of European safe assets as being euro-denominated, low default risk, high liquidity, homogeneous securities, robust to economic volatility disconnected from the fundamentals of any particular European economy. So, why create such a pool of assets?
Unified asset pricing benchmark
Asset pricing requires a benchmark. In the US, the Treasury curve is the ubiquitous reference for asset pricing in nearly all markets. In Europe, the relevant risk-free curve is generally the associated sovereign yield curve, or the Bund curve.
This causes fragmentation in capital markets, which engenders differences in financing conditions across euro-area countries, hampering economic convergence. The establishment of a truly homogenous European safe asset would provide a common euro-denominated risk-free reference rate facilitating convergence in financing conditions for small and medium-term enterprises and households across Europe, thereby reducing regional economic disparities and fostering capital market development.
Flights to quality and regional economic divergence
During times of economic stress, investors pile into safe assets. This ‘flight to quality’ effect generally reduces Bund yields, but not those of other European governments, imposing asymmetric costs throughout the euro area and amplifying spread divergence across the European government bond market.
These effects are a product of capital market fragmentation. A true European safe asset, untethered from the economy of any particular sovereign, would substantially reduce such negative asymmetries in capital market conditions. In fact, with a true European safe asset providing the reference rate, flights to quality into this asset should act as automatic economic stabilisers, placing natural downward pressure on rates across the curve during periods of economic stress.
Easing monetary policy transmission
Central banks implement monetary policy partly through the exchange of liquidity for safe assets in repurchase agreements and reverse repurchase operations. Where the collateral pool is fragmented across sovereigns of varying credit quality, and banks’ holdings are concentrated in domestic sovereign debt, monetary policy transmission becomes contingent on national sovereign stress and propagates unevenly through the euro area.
A true European safe asset, uniformly eligible and uniformly priced, would decouple transmission from national credit conditions. It would also provide a single reference curve for monetary policy, replacing the current patchwork of sovereign yield curves that introduces national idiosyncrasies into asset pricing, curve shape and ultimately policy efficacy.
Financial market development and bank-sovereign doom loop
Safe assets facilitate financial transactions, which often necessitate the pledging of such assets as collateral. Their homogeneity engenders information insensitivity among market participants, meaning they can change hands without costly due diligence. Generally, euro-area market participants use government bonds to facilitate transactions, and most banks hold large portfolios of such securities to comply with regulatory requirements. However, the absence of homogeneity is prone to fragment repo markets along national lines, hampering euro area-wide capital and financial markets. The establishment of a true European safe asset would eliminate this problem.
Relatedly, such an asset would reduce the correlation between banking sector and sovereign credit risk through diminishing the concentration of banking sector portfolios in domestic sovereign debt, via the substitution of banks into the European safe asset. This would diminish the strength of the doom loop that undergirded the euro crisis of the early 2010s: declining sovereign creditworthiness triggers bank losses, which worsens the sovereign balance sheet in expectation, which worsens expected credit losses for the banks.
Internationalising the euro
Lastly, a true European safe asset would bolster the role of the euro as an international reserve currency and support greater use of the euro in international trade. Reserve manager demand is dictated partially by market depth and liquidity; current euro area capital markets are sufficient in neither. Market depth is essential for the capacity to absorb large capital flows that accompany reserve currency status, and ample supply of a homogenous safe asset is a necessary precondition.
Further, fragmented institutional architecture imposes idiosyncratic (often country) risk on investors, which disincentivises holdings. A true European safe asset would diminish these frictions, support euro funding markets and, over time, make greater use of the euro in international finance and trade more plausible.
The overwhelming case for a European safe asset
The benefits of developing a true European safe asset are enormous. A low default risk, high liquidity, economic volatility-robust, homogeneous pool of securities, issued by a single supranational borrower is the next logical step in the development of the CMU/SIU.
The capital and financial market benefits from reducing market fragmentation, including diminishing banking sector risk, easing monetary policy transmission and facilitating the internationalisation of the euro, are hard to ignore. They should also be difficult to pass up for European policy-makers.
Conor Perry is an Economist at OMFIF.
This article is the third instalment in an OMFIF series on European debt. Read parts one and two here.
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