Jean-Claude Juncker and Giulio Tremonti (2010) have recently made a visionary proposal for the creation of a European Debt Agency that would administrate the issuance of European bonds (E-bonds). Each EU country would be able to issue E-bonds of up to 40% of GDP. They argue that the European Council could create the agency in less than a month. This E-bonds proposal shows careful thought and outstanding planning.
The proposal raises two types of questions.
- By increasing liquidity in the E-bonds market, it could reduce liquidity and result in higher funding costs for the remainder of each member country sovereign debt (Gros 2010).
If an optional “switch” between sovereign debt and E-bonds suggested by Juncker and Tremonti is available – and existing sovereign bond-holders switch in great numbers – the Eurozone members may have little say in how many E-bonds they can issue.
- The proposal offers little upside to the Eurozone “peripheral” countries that currently face a sovereign debt crisis.
Portugal, for example, will pay an estimated average interest rate of 3.6% on its existing stock of sovereign debt in 2010.
Even if, through the E-bonds, the Portuguese government were able to reduce the average interest rate on E-bonds stock of debt by 0.3 percentage points to the average interest rate of Germany’s government debt, Portugal’s financing costs would, at best, fall by 0.1% of GDP per year compared to its actual interest expenditure.
This assumes that Portugal would fund new debt amounting to 40% of GDP through E-bonds, which is likely not possible due to the “switch” option. At current rates of debt refinancing and new borrowing, the E-bonds would allow Portugal to fund new debt for possibly the next two years. At that point, Portugal would likely again face funding challenges.
This suggests that the overall benefits would likely be limited for “peripheral” Eurozone nations, even if it would ensure that the countries would continue have access to further credit in the near term. So, why go through all the trouble?
What is the most important impact of the E-bonds proposal? If one asks this question, then the answer seems obvious – it would change the legal basis of the debt from national to Eurozone.
- A May 2010 paper by Bucheit and Gulati points out that approximately 90% of Greece’s €300 billion of public debt is governed by Greek law. The paper insightfully argues that one option available to Greece is to carefully rewrite the law governing this debt, though taking care to comply with Greece’s constitution, international treaties on property rights and expropriation, and IMF membership obligations to make “a good faith effort to reach a collaborative agreement with its creditors”.
- Notwithstanding these issues, and while the paper authors do not make such claim, it might also be possible to substantially reduce the value of the debt obligations through changes in local debt laws (Buiter and Rahbari 2010).
Almost all of Portugal, Greece, Spain, and Ireland’s general government gross debt is governed by local law and most of the combined debt of these countries is held by non-residents (Cabral 2010). In addition, the governments of “peripheral” countries have very large contingent liabilities arising from their banking systems’ domestic and external liabilities. In fact, the “peripheral” countries’ net external private and public debt is estimated at 81.1% of combined GDP at the end of 2009, or €1.3 trillion (Cabral 2010)1.
- The fact that peripheral countries sovereign debt is governed by local law is of very high economic value to these countries. It is conceivable – at least in theory – for them to eliminate much of their debt by rewriting the law.
Therefore, it would not be in the “peripheral” countries national interest to exchange sovereign debt governed by local law through E-bonds likely governed by some other law and jurisdiction in order to benefit from some short-term small reduction in interest expenditure.
Past evidence (Reinhart et al. 2003; Manasse and Roubini 2009) suggests that the “peripheral” countries may be insolvent, since their net external debt is very large relative to the size of their economies (Cabral 2010).
Once the default route is taken, it is rational to go for a default with a very large haircut (Wolf 2005, Gros 2010, Buiter and Rahbari 2010, Johnson and Boone 2010); it is possible that it would be beyond the 72.9% observed in Argentina’s 2005 international debt restructuring (Sturzenegger and Zettelmeyer 2008). After all, the “peripheral” countries’ financial balance sheets and external imbalances are much worse than Argentina’s.
- Debt restructuring through changes in local debt laws would greatly facilitate this process (Bucheit and Gulati 2010) and, when the time comes, may come to be seen as the best available option by these countries’ leadership.
In this light, the E-bonds proposal must be seen in the context of a creditor-debtor negotiation game. It is in the national interest of creditor countries to change the terms of the negotiation through the elimination of the option that the “peripheral” countries currently have to restructure their debt through a change in local debt laws.
Over the next couple of years, the “peripheral” countries would likely refinance up to 40% of GDP through E-bonds subject to some not-yet-specified, but most certainly non-domestic, governing law and jurisdiction. As a result, the “peripheral” countries would likely not be able to restructure these E-bonds without the agreement of the creditors.
In effect, since restructuring E-bonds debt would be far more difficult, it is as if the E-bonds would be senior to the “peripheral” countries current sovereign debt (Gros 2010). The path of least resistance would be for these countries to default and impose far larger haircuts on sovereign debt (Gros 2010, Johnson and Boone 2010).
While various scenarios are conceivable, the proposed E-bonds might enable external creditors to limit the overall losses (i.e., the debt haircut) to something like 50% of net external debt outstanding at the end of 2009 (equivalent to about 40% of the peripherals’ combined GDP), and ensure even smaller losses to those creditors that switched from sovereign debt to E-bonds. Thus, the E-bonds would in practice implement a quasi “European debt restructuring mechanism” (Weder di Mauro and Zettelmeyer 2010).
The E-bonds ceiling of 40% of GDP for each country makes some sense. In fact, gross external debt of 40% of GDP – equivalent to about 139% (172% if Ireland is excluded) of the “peripheral” countries combined exports – would be at the upper end of what is generally considered in the academic literature as a sustainable level of external indebtedness (Reinhart et al. 2003, Manasse and Roubini 2009). This means that many experts would argue that the “peripheral” countries would be able to pay this lower level of external debt and avoid further debt crises.
French and German haircut losses
France and Germany are among the largest creditor nations to the “peripheral” countries. According to the Bank for International Settlements (BIS 2010) the total consolidated foreign exposure on an ultimate risk basis of French and German banks to the “peripheral” countries represented 15.7% of combined GDP.
In addition, these countries’ insurers and other non-bank financial intermediaries are likely to have further exposure.
- Any properly done due diligence would have identified the governing law issue of existing sovereign debt identified by Bucheit and Gulati (2010).
- It would likely also show that the E-bonds, if subject to European governing law, would be beneficial to creditor nations.
In opposition to the proposal, a German government spokesman has argued that the E-bonds proposal would require EU Treaty changes. Nonetheless, it is surprising to find that the German and French governments are also against the E-bonds proposal on the grounds that they would result in higher financing costs.
The E-bonds proposal is a brilliant piece of economic reengineering in favour of the Eurozone creditor countries – especially Germany and France. It is understandable and rational that the creditor nations should seek to improve the negotiating terms in preparation for all-but-certain sovereign defaults by the “peripheral” countries (Eichengreen 2010b).
- It is warranted and necessary that the Eurozone puts in place some orderly process for sovereign debt restructuring (Weder di Mauro and Zettelmeyer 2010, Eichengreen 2010b),
- The E-bonds proposal seems to be an important component of such a mechanism.
- It is also possible that the E-bonds are a first step in a long-term process towards fiscal and political union as argued by German Finance Minister Wolfgang Schäuble.
Nonetheless, the ends do not justify the means.
- This E-bonds proposal is somewhat similar to the US subprime’s “pick-a-payment” Adjustable-Rate Mortgage low teaser rates.
- It offers “peripheral” countries the option of picking a slightly lower E-bonds interest rate now, with much higher costs later on.
It runs counter to the principles of the Trichet proposal “Towards a Code of Good Conduct on Sovereign Debt Re-Negotiation” (Banque de France 2003).
It is a type of non-cooperative behaviour by creditor nations that invites tit-for-tat retaliation by debtor nations. Instead, Game Theory suggests that cooperative behaviour would result in higher total welfare outcomes. Therefore, let us hope that reason and mutual respect prevail.
Banque de France (2003), Towards a Code of Good Conduct for Sovereign Debt Re-Negotiation, Trichet-Proposal, January, Paris: Banque de France.
BIS (2010), Quarterly Review December 2010, Basel: Bank of International Settlements Press.
Buchheit, Lee and Mitu Gulati (2010), “How to restructure Greek debt“.
Buiter, Willem and Ebrahim Rahbari (2010), “Is sovereign default `Unnecessary, undesirable and unlikely´ for all advanced economies?” citi Global Economics View, 16 September.
Cabral, Ricardo (2010), “The PIGS’ external debt problem“, VoxEU.org, 8 May.
Eichengreen, Barry (2010a), “Ireland’s rescue package: Disaster for Ireland, bad omen for the Eurozone”, VoxEU.org, 3 December.
Eichengreen, Barry (2010b), “Europe’s inevitable haircut“, Project Syndicate, 9 December.
Gros, Daniel (2010), “The seniority conundrum: Bail out countries but bail in private, short-term creditors?“, VoxEU.org, 5 December.
Johnson, Simon and Peter Boone (2010), “Europe’s monetary cordon sanitaire“, Project Syndicate, 14 November.
Juncker, Jean-Claude and Giulio Tremonti (2010), “E-bonds would end the crisis“, Financial Times, 5 December.
Manasse, Paolo and Nouriel Roubini (2009), “`Rules of thumb´ for sovereign debt crises”, Journal of International Economics, 78:192-205.
Reinhart, Carmen, Kenneth Rogoff, and Miguel Savastano (2003), "Debt Intolerance”, Brookings Papers on Economic Activity, 1:1-74.
Sturzenegger, Federico and Jeromin Zettelmeyer (2008), “Haircuts: Estimating investor losses in sovereign debt restructurings, 1998-2005”, Journal of International Money and Finance, 27:780-805.
Weder di Mauro, Beatrice and Jeromin Zettelmeyer (2010), “European debt restructuring mechanism as a tool for crisis prevention”, VoxEU.org, 26 November.
Wolf, Martin (2005), “Argentina holds a weak hand“, Financial Times, 8 March.
1 The “peripheral” economies combined private and public gross external debt is estimated at €3.0 trillion. This estimate excludes Ireland’s International Financial Services Centre debt.