The Edhec-Risk Institute believes the unilateral measures taken by Chancellor Merkel on the sovereign debt markets, both on the short selling of sovereign bonds and credit default swaps, are counterproductive, inconsistent and liable to hinder European growth.
It has made this conclusion on the basis of numerous academic studies, including the position paper published in March 2010 by Professor Abraham Lioui entitled “Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales”.
Besides the fact that the lack of convergence on these issues with the US authorities leaves little hope of the measures being effective, Edhec-Risk Institute thinks the ban poses numerous problems and runs up against legal and practical obstacles that make it inapplicable or even counterproductive.
According to Edhec, it will be impossible for intermediaries and ultimately for regulators to verify investors’ holdings of the securities representative of the risk the credit default swaps are assumed to cover.
A strict obligation to use credit default swaps to hedge the risk of sovereign debt would prevent sovereign nations from issuing long-term debt, as the CDS market for hedges of more than ten years is relatively illiquid.
This prohibition makes it harder for countries to manage the interest rate risk on their debt actively, as their counterparties are no longer able to hedge the country risk of the interest rate swaps they may have entered into. This active management of the yield curve is a major component in the optimisation of the cost of public debt.
By making the market for hedging default risk more complex, the markets may be deprived of the debt of countries with low ratings, of investors, and thus of liquidity, which will inevitably increase the cost of this debt, says Edhec.
Even while European Commissioner Michel Barnier, in a letter to Professor Noël Amenc, director of Edhec-Risk Institute on 5 May 2010, was confirming that “a group of experts from the commission has been given the mission of studying the effects of CDS on price formation and the liquidity of the underlying bond market,” Chancellor Merkel’s unilateral decision, which renders the functioning of the sovereign debt markets responsible for the euro’s difficulties and the increase in the cost of credit for certain European countries, is inconsistent, the institute says.
“Once again, financial regulation decisions have been based more on preconceived ideas and populist posturing than on objective analysis of the facts. From that viewpoint, the position of the president of the European Commission who, without concerning himself with the work instigated on the subject by Commissioner Barnier, supports Germany’s reasoning, appears relatively incompatible with the requisite solidarity of the Commission and the consistency of European policy,” Edhec says.
A very strict definition of a naked sale would keep investors who finance public investment or companies that enter into contracts with sovereign nations or with state-owned companies from hedging the default risk of their counterparties. Edhec believes that at a time when public-private partnerships and private financing of public infrastructure projects are considered one of the drivers of global growth, making it harder to manage country risk may, at the very least, increase the costs of these partnerships and this financing and, at worst, prove a major hurdle to their development.
This limitation on the hedging of risk for companies exporting capital goods, engaged in major international contracts with the public sector, and for the credit institutions that finance them, is of a nature, if it is generalised, to slow down or render more difficult the exports of a large number of countries within the European Union, Edhec concludes.