Monday, October 8, 2012

The role of market beliefs in the European crisis and its policy implications.

Anne Laure Delatte discusses the results of a new OFCE report explaining the role of market beliefs/feelings in the European crisis. Her conclusion has 2 points: first, for the same economic situation, the spread between PIIGS countries and Germany changed depending on "market feeling". Second, and interestingly I think, she suggests that the impact starts on the CDS market.

Nos estimations confirment cette hypothèse pour un panel constitué de la Grèce, l’Irlande, l’Italie, l’Espagne et le  Portugal: sans une modification notable de la situation économique, les écarts de taux d’intérêt ont augmenté soudainement à la suite d’un changement dans les croyances de marché.
La question suivante est de savoir où se forment ces croyances du marché. Nous avons testé plusieurs hypothèses.  Finalement le marché des Credit Default Swaps (CDSs) joue ce rôle de catalyseur des sentiments de marché.

However, she proceeds to make a criticism of naked CDS that seem way too simplistic, saying that because most traders on the CDS market do not own the underlying bond of the CDS they're playing with, they should be defined as speculators.
Toutefois, rapidement, le produit d’assurance est devenu un instrument de spéculation : une grande majorité des opérateurs qui achètent des CDS ne sont pas propriétaires d’une obligation associée:
Because of this, she suggests that one policy implication is to forbid the buying of CDS by agents who do not own the underlying bond (a law banning those transactions will be in place starting in November).

However, it is not really clear that only sovereign bond holders are the only one who suffer from a sovereign default. For instance, we can look at this good op-ed by Turnbull and Wakeman recently in the WSJ
The premise that only sovereign-debt holders suffer when a country defaults is false. Many other agents are adversely affected by a default, and they should be allowed to purchase sovereign CDS.

 So again, the findings of the OFCE report are interesting, but the interpretation, and thus the policy implications that Delatte derives from it, might not be correct. However, her second policy proposal, that the CDS market would benefit from a clearing house instead of taking place over the counter, seems completely sensible to me.

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