Leonard Waverman is dean of the Haskayne School of Business, University of Calgary
We are now seeing runs on government bonds within Europe. If the country currencies were separate, this would be a classic currency run similar to the Asian crisis of 1997.
A short history of 1997 is as follows: The Asian ‘miracle’ appeared to disintegrate in July, 1997, when Thailand saw its currency fall as short term interest rates rose to 40 per cent. The crisis spread to Malaysia, Indonesia, South Korea and the Philippines, and Hong Kong. Government deficits and debt-to-GDP levels were high -- characteristics of the current European crisis.
While there were structural problems in a number of the economies, once the attack on currencies began, the herd pounced and the speculative bets were self-fulfilling; once the Thai Baht was falling, the speculators bets against the Baht were successful. A key point is that there are big winners in financial panics. The same situation exists today in Europe.
Let us take the example of Italian government bonds.
The chart below shows the yields on 10 year Italian bonds from 2001 until late 2010. The Chart shows that the yield (interest rate) went from 4 per cent to 6 per cent -- it is now above 7 per cent. The price of bonds is inversely related to the interest rate.
If bonds were issued in perpetuity, a $100 bond yielding an investor 4 per cent (or $4) would only be worth $66 if interest rates rose to 6 per cent. Someone buying the bond with a 4 per cent interest rate could earn 6 per cent on new bonds and hence would only pay $66 for the existing bond because $4/$66 is a yield of 6 per cent. For ten year bonds, the fall in the price works out to around 7 per cent for each 1 per cent rise in interest rates. Hence, the rise in yields on Italian government bonds of 3 percentage points (from 4 per cent to 7 per cent) would lower existing 10-year bond prices by some 20 per cent.
How do investors ‘profit’ in this market?
Let’s say investors ‘expect’ interest rates to rise in Italy, they will short the 10 year bonds, i.e. sell bonds they don’t own, under the expectation (which could be wrong) that the bonds can be bought tomorrow at a lower price. In reality this is done by borrowing an Institution’s bonds for a fee and then selling them. As long as the ‘bet’ that interest rates will rise is correct and the rise in interest rates means that the fall in the price of the bond that one buys back is greater than the fee for borrowing the bonds – there is a profit from such speculation. On the other side, those who hold the bonds during the interest rate rise are losers – this is the treasury generally. Short selling pits pessimists against those who hold or buy – optimists. In normal market conditions, both pessimists and optimists are important in determining the ‘right’ price or yield.
However, what we may now be seeing in Europe is a classic run on government bonds that, if there were no euro, would be a run on the individual country’s currency. That is, unease about political and economic events creates an environment for herd behavior – most believe or are led to believe that the risks of default have risen. Hence, rational and irrational selling of bonds occurs, and buyers demand higher and higher yields. First, Greece, then Italy, now Spain and France. Therefore, those most affected by these “speculative” attacks need to act. But how?
It may seem odd for a Business School Dean to be calling for substantial intervention in currency and bond markets. However, the herd behavior that is destabalizing the financial world must be stopped. These one way bets are yielding large profits to some at the expense of hundreds of millions of people. One has to add an element of potential loss to speculators.
“In July, 1997, within days of the Thai baht devaluation, the Malaysian ringgit was "attacked" by speculators. The overnight rate jumped from under 8 per cent to over 40 per cent. This led to rating downgrades and a general sell off on the stock and currency markets. By end of 1997, ratings had fallen many notches from investment grade to junk, the KLSE had lost more than 50 per cent from above 1,200 to under 600, and the ringgit had lost 50 per cent of its value, falling from above 2.50 to under 4.57 on (Jan 23, 1998) to the dollar. The then premier, Mahathir Mohammad imposed strict capital controls and introduced a 3.80 peg against the US dollar.” (Wikipedia).
By stopping the ‘hot money’ speculation, and imposing losses on those who were shorting the ringgit – (the 3.80 peg to the dollar meant that the sellers of the currency at 4.57 to the dollar expecting to make money from a further depreciation of the ringgit now had a 16 per cent loss!), the attacks stopped.
At the time, Malaysian officials were roundly criticized by economists for interfering with the sacreds of sacreds -- free capital markets. Recently, the International Monetary Fund released a Staff paper stating that capital controls could be a part of the arsenal of a well- functioning economy or as the paper says to put “sand in the wheels “ of short term investors. 1 Revisionists have taken over the King’s court.
The manner in which the yields on Greek and now Italian and French bonds have soared, the vast differences between Greek and Italian economies – suggests we are seeing a classic speculative run – not on currencies, but on government bonds, one European economy after another. And which economy is next, the U.K., the U.S.?
It is time to put “sand in the wheels” of short term or hot money speculators, or simply to reduce herd behavior – by changing the nature of what appears to be one-sided winning bets. Malaysia did that by imposing capital controls and by appreciating the ringgit.
What can Italy, the G20, the IMF do? There are several possible ways of controlling shorting bonds which need to be analyzed -- generally controlling the supply, the demand and increasing the costs of activities in the bond market. Lowering the supply of Italian 10 year bonds will raise their price, and lower yields -- however with governments needing more money, lowering supply is not an option. A specific Tobin tax -– a tax on short sales of bonds is “sand in the wheels”.
A more effective mechanism would be raising the margin requirements (or the fees for borrowing) but only on short sales. On Nov. 9, LCH.Clearnet, the world’s largest centralized and clearing facility of European government bonds markets, raised margin requirements on all its members’ holdings of Italian bonds. This signaled higher risk and higher new cash requirements. The result was a massive sell off of Italian bonds and a surge in yields. “Sand in the Wheels" should be on short sales only and for only a short period. Moreover, these new margin requirements need to be across the board on ALL European countries' bonds. This will help control herd behavior swinging from country to country.
Finally, the best action to lower yields is by increasing demand. Many influential economists are urging the European Central Bank to be the “Lender of Last Resort”. The U.S. Federal Reserve and the Bank of Canada are able to lend money to solvent financial institutions that are experiencing serious liquidity problems. The ECB has no such role. Many European countries want the ECB to guarantee the bonds of member states – but Germany is adamant that the ECB have no such role. The German fear of hyperinflation (like 1923) is the reason trotted out to explain this deep seated reluctance. But few can seriously see high inflation as a threat today. The real reason for German reluctance could be that several governments in Europe are insolvent -- bankrupt -- and guaranteeing their bonds is a clear huge subsidy as well as encouraging continued flagrant deficits. While one can understand the German position abstractly, it makes little sense in reality. First, countries such as Italy and France are not insolvent. Moreover, as the proverb says – the horse has left the barn. And if the ECB is constrained to not act as a Lender of Last Resort, not only will the horse die but the barn will burn down.
Speculative attacks can no longer be associated only with less advanced economies. If this is what we are witnessing in Europe, capital controls and a Lender of Last Resort are the answers.
1 - See Capital Inflows: The Role of Controls, Jonathan D. Ostry, Atish R. Ghosh, Karl Habermeier, Marcos Chamon,. Mahvash S. Qureshi, and Dennis B.S. Reinhardt. International Monetary Fund, February 2010