A number of European politicians and economists are hailing the euro-bond proposal as the only viable solution to the region’s sovereign-debt dilemma.
In their view, joint issuance of euro bonds would take advantage of the creditworthiness of core European Union countries such as Germany without throwing their deficit and debt ratios out of whack. Yes, goes the argument, there are a few technical hurdles, but they can be easily overcome.
What proponents of euro bonds ignore is that, unless the initiative stems from a broader process leading to economic and fiscal union, it risks taking the euro area into an even more disruptive phase in the future. Euro bonds would buy the weaker European countries time to complete their economic and fiscal adjustments. However, if these adjustments failed, or if the appetite for reforms and fiscal austerity waned, the weaker countries would have to return to issuing domestic bonds at prohibitively high yields and may ultimately default. If they were also required to post official reserves and other state assets to secure the euro bonds, they would risk losing everything should a more serious crisis strike.
For the fiscally sounder countries, the risk is that the guarantees on euro bonds will become their liabilities, thus causing their own government debt to balloon. Political and economic tensions between euro-area countries could arise from defaults and demands for reparations. And even before we got there, the rating companies may decide that euro bonds warrant a downgrade of the existing debt of the AAA countries.
Red and Blue
The advantages and risks of euro bonds depend on how they are structured. One of the proposals getting a lot of attention was formulated in 2010 by economists Jacques Delpla, an adviser to French President Nicolas Sarkozy, and Jakob von Weizsacker, an economist at Bruegel, a Belgian think tank. They envision euro-area countries issuing two classes of bonds, which they labeled “blue” and “red.”
Blue bonds would be jointly backed by the euro-area nations for up to 60 percent of the gross domestic product of the region. Additional borrowing would have to be financed by red bonds, which would be separately issued by each country and would be junior to the blue ones. Red bonds issued by the fiscally weaker countries would carry higher yields than blue bonds. Red and blue bonds would gradually replace existing government bonds throughout the euro region. Each country’s ability to access euro bonds would be regulated by an oversight board on the basis of fiscal and macroeconomic benchmarks.
Over time, as the stock of blue bonds outstanding rose toward 60 percent of the region’s GDP, the euro-bond market would approach the size of the U.S. Treasury market, thus achieving greater levels of depth and liquidity than European markets have today. This would lower bond yields. The relatively low debt ratio covered by the blue bonds, their senior status and the risk diversification would secure a AAA rating for these securities. On the other hand, the red bonds issued by the weaker euro-area countries would probably have an even lower rating than their existing bonds.
Implementing the euro-bond project may be more difficult than suggested by its proponents. First, the stock of government securities outstanding is significantly smaller than suggested by total debt ratios. For instance, German federal government securities are equal to only about 40 percent of GDP. Germany, as well as the Netherlands and Finland, are unlikely to support euro-bond issuance in excess of that level.
In addition, joint issuance of bonds would amount to an implicit transfer from the stronger to the weaker countries. The more creditworthy countries would demand some type of offsetting compensation, and doing so would be a contentious affair. The speed at which member countries would be allowed to issue blue bonds would also pose problems given countries’ different annual borrowing needs.
Although the blue-red bond proposal has been strongly backed by Italian politicians such as Finance Minister Giulio Tremonti, it entails significant risks for the fiscally weaker countries. For one thing, the project explicitly envisages the possibility of defaults on the red bonds -- something that would make high-debt countries like Italy more vulnerable. Second, existing longer-maturity bonds would become riskier because the market would anticipate these bonds being rolled over as red bonds, once the room to issue blue bonds runs up against the 60 percent ceiling. This would inflict losses on banks, insurance companies and pension funds.
If a weak country didn’t restore fiscal balance, it would run a high risk of defaulting either during or immediately after the issuance of the blue bonds because investors would shun its red bonds as excessively risky. Any default would be particularly damaging if blue bonds were backed by collateral such as a nation’s gold and currency reserves. Once such a country defaulted it would find itself with no remaining assets to back International Monetary Fund loans and possibly have no choice but to return to a national currency.
To understand why Germany and other prudent countries resist the euro-bond option, consider what could happen in the event of a default by Italy and Spain. Based on the 60 percent-of-GDP version of the plan and assuming a 50 percent recovery, the cost for Germany would be 216 billion euros ($300 billion), or 8.4 percent of its GDP. This would have traumatic economic and political repercussions. Anti-euro and nationalistic political movements in northern Europe would gain support, threatening the continent’s political equilibrium.
Proponents of the currency union have been arguing that only a crisis would spur a move toward fiscal and political union. Given the severity of the debacle now unfolding, we can only hope they are right. However, on their own euro bonds look like the wrong fix for a failing currency union.
(Riccardo Barbieri is chief European economist at Mizuho International. The opinions expressed are his own.)
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