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Conditions for turning the ex ante risk premium into an ex post redemption for EU government debt

Colignatus, Thomas (2011): Conditions for turning the ex ante risk premium into an ex post redemption for EU government debt.

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Abstract

Basel III classifies government debt as risk free while actual interest rates in the European Union (EU) show large differences not only because of liquidity but mainly because of the risk of default, as also reflected in credit default swaps. IFRS / IASB insists that there are risks involved indeed and that fair value accounting applies, which causes bank capital to collapse. Speculation sends governments and banks in joint distress. Curiously such debt defaults may not happen so that creditors do not need to cover losses. The risk premium then becomes a reward for taking a risk that does not materialize. Contagious fears create risk premia that destabilize government debts and national economies. A solution is to regard the risk premia as potential redemption that turns into actual redemption when the loan is served to maturity. A EU law may make this mandatory without serious restrictions to the credit market. The rule would be that governments under threat of default would issue only annuity loans with a centrally determined rate of interest. The market sentiment of increased risk then shows up in shorter maturities. Governments that can borrow only at shorter maturities but at higher annual liquidity requirements meet with strong incentives to better manage their economies. The paper investigates the conditions involved. An important distinction appears to exists between the risk free rate, the credit default risk premium, the liquidity premium and a stigma factor. While much of the debate in the EU seems to be about reducing the risk premium, the distinction between ex ante risk and ex post redemption allows to identify that true EU policy costs concern irrational stigma factors. Notably, aversion against Southern European debt, that differs from the risk free rate and the default risk and liquidity premiums, has no rational base but can persist because it is rewarded.

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