My Name Is Bond, Euro Bond

The Italian finance minister, Mr. Tremonti and his Luxembourgian counterpart, Mr. Jean-Claude Juncker, in an article which appeared in the Financial Times on 5 December, launched the proposal of establishing a European Debt Agency, which should replace the European Financial Stability Facility, when this expires in 2013. The proposal is not new. The original one goes back to Jacques Delors in the 1980s, and has been recently rejuvenated by the recent Monti Report to President Barroso (Monti 2010, see also Basevi 2006). Initially the idea was intended to provide a new debt instrument for financing pan-European infrastructures.

According to the Tremonti and Juncker version, a new European debt instrument should gradually replace national public debts. Governments should issue half of their new issues in the form of Eurobonds, until these reach 40% of the GDPs of each member country (and of the Eurozone as a whole). Countries that face serious difficulties in accessing capital markets may – in exceptional circumstances – cover 100% of their issues with European debt.

The proponents argue that the Eurobonds would achieve two important objectives:

  • Creation of a bond market comparable, in size and liquidity, to the US Treasury Bill market; and
  • Termination of speculative attacks against sovereign debts in the Eurozone.

Despite these proclaimed virtues, the proposal was immediately rejected by Chancellor Merkel and President Sarkozy.

The plan’s critics have argued that the new bonds would weaken the market incentives for fiscal discipline, by allowing spendthrift governments to borrow at lower costs, and would penalise virtuous countries, whose borrowing costs would likely rise.

This moral hazard problem is important, but two issues deserve far more attention – fiscal sovereignty, and default.

The Eurobonds and fiscal sovereignty

Public debt has a positive market value only if those who buy it believe that the state will be able to repay it in the future by running budget surpluses. Since the current European budget is by no means large enough to repay a debt equal to 40% of European GDP, one of the following must be true. Either the bonds will have no market, or, if they do, it must be because investors believe that the new bonds will be eventually reimbursed by the budget surpluses of virtuous countries (or by a high European-wide tax).

But why should the Germans be willing to pay high taxes for financing the high Greek, Irish, and Portuguese social spending, which their fellow Europeans cannot afford? In liberal democracies there can be “no taxation without representation”. Hence the following must be true.

The Eurobonds require a fiscal union where high debt countries lose (entirely or partially) their fiscal (and hence political) sovereignty. Minister Tremonti represents a European country, Italy, which is second only to Greece in terms of its debt-to-GDP ratio. Would he be willing to give up fiscal sovereignty in order to accomplish his proposal?

The Eurobonds and default

The original idea, as mentioned, was intended as a means of financing infrastructure and was advanced in a context of financial stability. Today, it has been revived as a mechanism for resolving sovereign debt crises. The proposal shares some features with the so-called “Exchange Offers” employed successfully in the crises of Pakistan, Ukraine and Uruguay over the past decade.

This is how such deals work. The Sovereign debtor, threatening to default, proposes to the creditors that they accept “voluntarily” the new bonds in exchange for the existing securities. The new securities are worth less (the loss is called haircut), but are senior relatively to the old ones, as they are given priority in the repayments.

  • If well planned, the offer may be convenient for creditors, who, by accepting it, lose less than they would by refusing and prompting a default.
  • The offer is clearly convenient for the sovereign debtor, since it reduces the value of his debt and allows him to continue to access the international capital markets at reasonable rates (which would not be the case if it became insolvent).

This procedure, however, does not require an international guarantee, as in the case of the Eurobonds. More importantly, the conversion of old into new debt makes sense only if made as soon as possible (clearly, before default). By contrast, the European agency in the Tremonti and Juncker proposal would become operational only after 2013.

Were it to be approved in these terms, the effects would be to ignite the default of countries at risk (this is exactly what seemed to be happening). It would also be following Mrs. Merkel’s statements on the need to bail in the private sector – which is essentially what the proposal would accomplish.

Who would ever want to hold Greek, Irish, Portuguese debt today, knowing that in 2013 this debt will be downgraded to a junior debt, and thus knowing he would suffer today a capital loss for sure? (See also Gros 2010 on this point). The answer is no one, unless the European Debt Agency (which does not exist yet) could commit to convert the old into new debt at par in 2013, which would obviously make the new debt instrument completely useless for solving the Eurozone debt crisis.

Conclusion

The Tremonti-Juncker project is a good idea for financing infrastructure and increasing market liquidity in good times. Yet it requires a large loss of fiscal sovereignty by high debt countries. Because of its timing, it’s a bad idea for solving the debt crisis of Europe.

References

Monti, Mario (2010),“A new strategy for the Single Market – at the service of Europe’s economy and society”, Report to the President of the European Commission José Manuel Barroso, May.

Basevi, Giorgio (2006), “Un’Agenzia europea del debito pubblico”, I mercati finanziari internazionali. Nino Andreatta e la politica economica, a cura di Paolo Onofri, Il Mulino, pp. 113-18.

Gros, Daniel (2010), “The Seniority Conudrum”, VoxEU.org, 5 December.


Originally published at VOX and reproduced here with permission.

One Response to "My Name Is Bond, Euro Bond"

  1. Guest   December 16, 2010 at 10:15 pm

    I would like to make a few comments on the so-called European sovereign debt crisis.I will start with some data:top five countries with highest foreign debt as percentage of GDP:1-Luxembourg 3854%2-Ireland 1004%3-Liberia 606%4-Netherlands 470%5-United Kingdom 416%top ten countries with highest public debt as percentage of GDP:1 Zimbabwe 282.60 2009 est.2 Japan 189.30 2009 est.3 Saint Kitts and Nevis 185.00 2009 est.4 Lebanon 156.00 2009 est.5 Greece 126.80 2009 est.6 Jamaica 124.50 2009 est.7 Italy 115.20 2009 est.8 Singapore 113.10 2009 est.9 Iceland 107.60 2009 est.10 Sudan 103.70 2009 est.top 5 countries with highest deficit in the EU (%)Greece -15.4Ireland -14.4United Kingdom -11.4Spain -11.1Latvia -10.2so tell me where is the insolvency of Portugal?lot of people need to understand that the entire West is insolvent.The media and the goold ol’boys decided to focus their attention on the so-called PIIGS (literally name-calling), forgetting that countries like the UK, the US, France and even Germany have a huge debt crisis on their own.WHat makes you think they’ll manage to pay their debt in the same way Portugal or Spain will? The UK’s foreign debt for instance accounts as high as 420% of its GDP! The US has a public debt of almost 100% of it’s GDP and holds the biggest debt in the entire world! COuntries like Portugal, Ireland, Spain, are small fish. Attack them, if you feel that will make you gain time or something.Although I think we should be tackling this crisis together, for decades the west has been overspending. The PIIGS are (or represent) the west at its best, overindebted, and growing slowly (especially when compared to developing economies). It won’t be until people realise this that the so called debt crisis will be solved. Portugal’s public debt represents a small percentage of the US or the UK or France’s debt…. what is more worrying to the World? Or the IMF? SMall little Portugal or bigger countries, that have debts that have gone way beyond their control? thinking otherwise is either not wanting to see it, or being extremely gullible.The rating’s agencies behaviour is something to laugh at also, how they still keep countries like France, the UK, or even the US with triple As is something only in a surrealistic world we can fathom (or a sad world, where there are two weighs two measures). Portugal’s deficit is lower than Britain’s. The rating’s agencies even kept Ireland with an AA rating when its yields were way past salvation (after all the hedge and vulture funds fled like crazy when they heard Angela Merkel mention the haircut). They only downgraded Ireland a few weeks ago. Fair treatment to Portugal and SPain? Hardly. It’s undebatable.But go on debating on the insolvency of the PIIGS, keep using the acronym as it didn’t mean discrimination. We all know that in the end, unfortunately, the bill will be left at everyone’s doorsteps, and whilst Portugal’s debt is small in global terms, I wonder what the US, the UK, France et al will be saying when they get theirs. And please don’t take me wrong, I may be a little piggy but I am still part of the west. I am just giving my two euro cents.I’d like to see Mr. Roubini answer these questions:I’d like to see a serious reply to my post.-Why is the media so focused on the PIIGS when the fact is – the entire west is indebted?-How do you explain the rating’s agencies behaviour?Just trying to bring a bit of scepticism into the debate.Yours truly,