In 1958 Merton Miller and Franco Modigliani published an article outlining the idea that in perfect capital markets the value of a company does not depend on its financing structure. The value of assets of a company does not increase if you raise the weight of debt in its financing structure, as the value of equity simply falls by the corresponding amount. In other words, the weighted average cost of capital of a company stays constant independent of the weights of debt and equity in its financing structure because an increase in the debt burden results in the equity becoming more risky and thus equity holders requiring higher returns.
Real life capital markets are far from perfect and imperfections exist in the form of transaction costs, taxes, subsidies and costs of financial distress, to name the most common ones. Thus, the proposition was amended to take into account the effects of imperfections. The conclusion from that – it is possible to increase the value of a company by financial engineering, but only by as much as it can exploit market imperfections such as tax deductibility of interest payments to its advantage. However, the effects of different imperfections can be partly or fully mutually offsetting, for example, the present value of the expected costs of financial distress can outweigh the gains from tax deductibility of interest.
In 2010 Jacques Delpla and Jakob von Weizsäcker came up with the idea of EU countries pooling up to 60% of GDP of their national debt under joint and several liability as senior sovereign debt or the so-called “blue bonds”, while any debt above the 60% of GDP threshold would be issued as national and junior debt or “red debt”. In November 2011 the European Commission published a green paper discussing different aspects of the above scheme along with two other options. Support for the blue bond / red debt scheme has recently been reiterated by Jeffrey Frankel. According to him, relieving countries of responsibility for debt up to 60% of GDP would be substantial assistance to the most troubled countries, although he also admits that it would not by itself put them on a sustainable debt path.
However, if in perfect capital markets the value of a company does not change when changing the relative weights of debt and equity in its financing structure, it is also unreasonable to assume that in perfect capital markets additional value could be created for governments (and ultimately for taxpayers) in the euro area by replacing a part of the national debt with joint blue bonds that would be senior to the other debt. The inevitable result would be that the interest rates on red debt would rise to reflect the much higher risk and the total weighted average cost of borrowing for the respective national government would not change.
Similarly as with changing the capital structure of a company, the blue bond / red debt scheme can only create additional value by exploiting imperfections in the capital markets. Perhaps the most important of them are transaction costs associated with liquidity differences. Depla and von Weizsäcker have also argued that as the joint market in blue bonds would be much more liquid than the present markets for national debt, the greater liquidity would result in lower borrowing costs and have estimated the gain to be about 30 basis points on average. European Commission is more conservative in its assessment and puts the expected yield gain due to better liquidity in the range of 10 to 20 basis points.
However, capital market imperfections would also work in the other direction – by reducing the attractiveness of red debt. If liquidity in the “red” national bond markets goes down further, investors would require even higher rates on the red debt to compensate for the reduced liquidity and increased transaction costs in addition to the much higher expected loss in the event of default. If the European Central Bank deems the red bonds ineligible as collateral for its refinancing operations, which is likely at least for the most heavily indebted countries, their attractiveness would go down even further. Depla and von Weizsäcker mentioned these issues, however, did not make any attempt to quantify them and such quantification would also be difficult. However, a back-of-the-envelope calculation shows that if for a country with the total debt to GDP ratio of 100% the rates on “red debt” went up by further 30 basis points as a result or lower liquidity, it would be enough to nullify the positive liquidity effect of 20 basis points obtained by joint issuance of the blue bonds.
Although the liquidity advantage of the blue bonds is obvious, the countries that would likely benefit from them most are such Eurozone members as Finland, Austria and the Netherlands that have government debt to GDP levels below or slightly above the 60% threshold. The blue bond / red debt scheme would do little if anything to alleviate the debt burden in the most heavily indebted countries. In addition, David Veredas has pointed out the problem of “tail risk” with respect to bond yields in the peripheral euro zone countries in the current situation of high uncertainty.
The solution to the Eurozone debt crisis is likely to emerge from a combination of reducing public current expenditure, increasing public investment expenditure, privatization of state assets in the most heavily indebted countries and using the proceeds to reduce indebtedness, carrying out product and labor market, tax and education reforms, moving towards a banking union, the ECB using its Securities Market Program to provide countries with temporary relief from financial market pressure or even further debt restructuring. However, the blue bond / red debt scheme cannot be the silver bullet to kill the Eurozone crisis beast.
Delpla, Jacques and Jakob von Weizsäcker (2010). “The Blue Bond Proposal”. Bruegel Policy Brief, Issue 2010/03, May 2010
European Commision (2011). “Green paper on the feasibility of introducing Stability Bonds”, November 23, 2011
Frankel, Jeffrey (2012). “Could Eurobonds be the answer to the Eurozone crisis?”, VoxEU.org, June 27, 2012
Modigliani, Franco and Merton H. Miller (1958). „The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic Review 48 (3), pp. 261-297
Veredas, David (2012). “Mutualising Eurozone Sovereign Bonds? First of All, Tame the Tails”. VoxEU.org, June 24, 2012.
2 Responses to “Applying the Modigliani – Miller Theorem of Capital Structure to Governments: Why ‘Blue Bonds’ Are Not the Silver Bullet to Kill the Eurozone Debt Crisis”
Swedish holding companies are supposed to be attractive for corporate tax planning purposes; do you know in which exact way they are favorable?
Although the liquidity advantage of the blue bonds is obvious, the countries that would likely benefit from them most are Finland, Austria and the Netherlands that have government debt to GDP levels below or slightly above the 60% threshold.