How the Eurosystem's Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (and What to Do About it)

42 Pages Posted: 1 Mar 2006

See all articles by Willem H. Buiter

Willem H. Buiter

Citigroup New York; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); Columbia University

Anne Sibert

Birkbeck, University of London; Centre for Economic Policy Research (CEPR)

Date Written: December 2005

Abstract

Market interest rates on sovereign debt issued by the 12 Eurozone national governments differ very little from each other, despite the credit ratings of these governments ranging from triple A to single A, and despite significant differences among their objective indicators of fiscal-financial sustainability. We argue that this market failure is at least in part due to a policy failure: the operational practices of the European Central Bank and the rest of the Eurosystem in its collateralised open market operations convey the message that the Eurosystem views the debt of the 12 Eurozone sovereigns as equivalent. The euro-denominated debt instruments of all twelve Eurozone governments are deemed to be eligible for use as collateral in collateralised lending by the Eurosystem. They are in addition allocated to the same (highest) liquidity category (Tier One, Category 1) as the debt instruments of the Eurosystem itself and subject to the lowest 'valuation haircut' (discount on the market value). Haircuts also increase with the remaining time to maturity. This discourages the use as collateral of longer maturity debt which would be more likely to reveal differences in sovereign default risk. We propose that the size of the haircut on each debt instrument be related inversely to its credit rating. A further re-enforcement of the market's ability to penalise and constrain unsustainable budgetary policies would be to declare the sovereign debt of nations that violate the conditions of the Stability and Growth Pact to be ineligible as collateral in Eurosystem Repos.

Keywords: Sovereign default risk, collateralised loans, Eurosystem

JEL Classification: E58, E63, G12

Suggested Citation

Buiter, Willem H. and Sibert, Anne, How the Eurosystem's Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (and What to Do About it) (December 2005). CEPR Discussion Paper No. 5387. Available at SSRN: https://ssrn.com/abstract=887541

Willem H. Buiter (Contact Author)

Citigroup New York

Citigroup Global Markets Inc
388 Greenwich Street
New York, NY 10013
United States
+12128162363 (Phone)
+12128168970 (Fax)

HOME PAGE: http://willembuiter.com/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Columbia University ( email )

420 West 118th Street
New York, NY
United States

Anne Sibert

Birkbeck, University of London ( email )

Malet Street
London, WC1E 7HX
United Kingdom
+44 20 7631 6420 (Phone)
+44 20 7631 6416 (Fax)

HOME PAGE: http://www.ems.bbk.ac.uk/faculty/sibert/index_html

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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