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Julian D. A. Wiseman
Abstract: the statement of the EU5 in Korea suggests that the grave problems caused by fungibility have not been considered.
Publication history: only at www.jdawiseman.com/papers/finmkts/20101114_outstanding_debt_current_instruments.html. Usual disclaimer and copyright terms apply.
Contents: Introduction (statement of the EU5); Fungibility; The Incentive.
According to no obvious official sources but multiple unofficial sources (Financial Times, Wall Street Journal, The Guardian) with varying punctuation and paragraphing, as if transcribed from a spoken statement:
Terms of Reference by the Finance Ministers of France, Germany, Italy, Spain and the UK
At its meeting on 29 October 2010, the European Council discussed the future arrangements for ensuring economic and financial stability in the European Union.
Whatever the debate within the euro area about the future permanent crisis resolution mechanism, and the potential for private-sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any programme under current instruments.
Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements.
The EFSF is already established and its activation does not require private sector involvement. We note that the role of the private sector in the future mechanism could include a range of different possibilities, such as a voluntary commitment of institutional investors to maintain exposures, a commitment of private lenders to roll over existing debt or the inclusion of collective action clauses in future bond emissions of euro area Member States.
This ill-considered statement incentivises some interesting behaviour.
Let us consider a particular Irish gilt, the IE00B4TV0D44, it paying a coupon of 5.40%, and maturing on 13 March 2025. First issuance, in October 2009, was of €7bn sold by syndicate. Second issuance, in January 2010, was of another €1bn, sold by auction.
If an investor had bought €100mn at each issue, the investor would have a single holding of €200mn. The bond is not separated into varietals: ‘first issue’ and ‘second issue’. Likewise, if today an investor were to buy some of this in the market, it would not be labelled with its date of issue: it is just IE00B4TV0D44. There is a single security.
Next imagine that, in 2014, the Irish National Treasury Management Agency issues more of this. Such further parts would be equally indistinguishable from—would be fungible with—a parcel issued in 2009 or 2010. So in the event of Irish sovereign financial distress, the EU5’s “role of the private sector” would have to apply to the whole of IE00B4TV0D44, or to none of it: the security could not be separated into pieces issued before and after a cutoff date.
The above statement of the finance ministers says clearly that future requirements for “private-sector involvement” in default costs would “not apply to any outstanding debt and any programme under current instruments”. Exempting all instruments first issued before 2013! Did they really think this through? Were they aware that could include most of the eurozone government debt issued for the next several decades?
Euro-zone sovereigns, particularly those that do not currently have a long bond, should therefore issue several bonds longer than the current longest: perhaps with maturities of 30 (if not already existing), 50 and 100 years. The quantity could be as small as €1mn of each. It should be done immediately, in case pre-2013 is changed to pre-2011. This would provide the sovereign with long-term funding vehicles that might be subject to better inter-government guarantees, and hence would be preferred by investors. (Italy already has a 5% Sept 2040, but Ireland has nothing beyond 2025, so this trickery is more important to the latter.)
Of course, if this isn’t so, and such guarantees or pseudo-guarantees as might exist are equal, there is no requirement to issue more of these securities. Issuing such a small amount gives the sovereign some free options of very large size.
Finally, observe that even without such blatant mischief, the statement incentivises sovereigns to re-open and re-re-open current long bonds, rather than creating new ones.
|— Julian D. A. Wiseman|
14th November 2010
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