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Professional blogger and full time investor in real estate, stocks and bonds. Focus is on cross over investing, multi asset and long-short. Started a small private hedge fund.
  • Multiple Equilibria  0 comments
    Jul 27, 2014 9:20 AM

    The term "Multiple Equilibria" resurfaced in 2011-2012 during the height of the European Sovereign Debt Crisis. There are a few ways to describe this phenomenon. When markets┬┤ believe governments can pay their obligations, the governments are rewarded with low borrowing costs.

    If markets doubt governments, interest rates soar. The market's belief creates outcomes that can become self-fulfilling. Either low interest rates stoke inflation or high rates cause default, both defined as the "bad" equilibria. Another explanation of multiple equilibria is the close relationship between liquidity and solvency. When a country issues debt in its own currency and has the ability to print, its central bank can mask insolvency via monetization. When a country issues debt in a foreign currency, it relies on a foreign central bank that can print freely. When a liquidity crisis occurs, the country with foreign currency debt can experience sudden shift in perception of solvency risk as it cannot access unlimited liquidity independently.

    Paul De Grauwe published a paper in 2012 titled "Mispricing of sovereign risk and multiple equilibria in the Eurozone". He found that directionality in sovereign bond spreads became much closer correlated with debt to GDP ratios post the 2008 financial crisis. This strength in correlation was specifically for countries that do not issue in their own currency, such as those in the Euro-zone. De Grauwe did the same exercise for countries that issue debt in their own currency. He found that Debt to GDP ratios had no meaningful statistical significance on their respective sovereign bond spreads.

    De Grauwe concluded that there was a "structural break" for Euro-zone countries issuing debt in a currency (the Euro) they can basically not control. And so a rise in the Debt/GDP ratio can create equilibria that are levels of yields presenting differences in liquidity & solvency premiums. Figure 1 is a depiction of the framework the downward sloping S-curve has points A, B and C where demand can suddenly shift.

    Figure 1: Multiple Equilibria Framework

    (click to enlarge)

    What figure 1 tells is that is when demand shifts from A to B, the outcome could become C as a liquidity crisis degenerates into a solvency crisis. This is a theoretical framework, no doubt. But as De Grauwe argues, the yield differences in figure 1 can converge/diverge because of fragility driven by two fear factors. These are 1) fear of insolvency creating conditions that make insolvency more likely and 2) fears enlarge and through contagion can take panic proportions. And so fears of further increases in Debt/GDP ratios rather widen than narrow the rate differentials. De Grauwe still sees the potential risk for a self-fulfilling solvency and liquidity crisis in the Euro-zone that creates a bad equilibrium. This is a combination of high nominal rates and economic downturn that has to apply further budget austerity, which would cause a further rise in Debt/GDP ratios.
    Is De Grauwe right? The one lesson that has been learned over the past years is that central banks from the US, UK, and Japan are willing preemptively inject liquidity into their bond and equity markets to avoid the bad equilibria. The ECB lags that process however and is still contemplating how to implement quantitative easing. In De Grauwe's terms with large debt issued in foreign currency, the absence of abundant liquidity keeps Euro-zone bond markets at risk to some degree.

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