Can we have euro bonds without cross-country subsidisation? Yes, we can

Angelo Baglioni, Umberto Cherubini

12 October 2011

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In the policy debate about euro bonds, it is often argued that they would benefit high-debt countries at the expense of low-debt countries: the latter would pay a higher risk premium on their debt, since the guarantee they provide to other countries would put an expected liability on their budgets (see for instance on this site Manasse 2010, Gross 2011, and Suarez 2011). On the contrary, we believe that it is possible to design euro bonds in such a way that they are able to lower the cost of servicing the public debt for some countries in the Eurozone, without increasing the cost for the others. Moreover, they are likely to give governments an incentive to curb their deficits, thus avoiding any moral hazard effect. In this column, we briefly explain how this can be done (see our working paper Baglioni and Cherubini 2011 for more details).

In our view, euro bonds should include the following:

  • European Debt Agency. A European Debt Agency (EDA) should issue the bonds in the open market and lend money to the public sectors of the Eurozone.
  • Threshold limit. Governments should borrow from the EDA up to a specific level of the debt-to-GDP ratio (say 40%).
  • Seniority. The claim of the EDA should be senior relative to the other governments' liabilities.
  • Cross-guarantee. The euro bonds, issued by the EDA, should be guaranteed by the primary surplus of the Eurozone as a whole.
  • Diversification. Thanks to the cross-guarantee, any worsening of the public sector balance in some countries would be be offset by an opposite evolution in some other countries of the Eurozone.
  • Cash collateral. The EDA should be endowed with a cash deposit, funded by governments, equal to the expected loss on its own overall exposure with Eurozone governments. This is made to ensure that euro bonds can be issued at the risk-free interest rate. The EDA should pass on this benefit to the sovereign borrowers, who in turn would be able to borrow from the EDA at the risk-free rate.
  • Avoidance of cross-country subsidisation. To avoid cross-country subsidisation, the burden of the cash deposit should be shared among countries in proportion to their credit risk. To be more specific, we propose to share the burden in proportion to the cash deposit that each government should post if it were to issue senior debt of its own and make it risk-free. The rationale is that countries could provide guarantee for the euro bonds either by their reputation or cash.

While most of the above features have already been suggested by some proponents of euro bonds (see Monti 2010, Juncker-Tremonti 2010, and Delpla-Weizsacker 2010), the last suggestion – avoiding cross-country subsidisation – is more innovative and deserves some explanation. Consider the case in which the public debt of a country is split between a senior tranche and a junior one. This tranching operation at the national level (‘domestic tranching’) would not change the overall cost of debt: the gain for the public obligor on the senior tranche is offset by the additional cost on the junior tranche (this property is the Modigliani-Miller theorem applied to the public sector). Contrary to domestic tranching, euro bonds are able to lower the average cost of public debt, thanks to the cross-guarantee and the diversification effect. This reduction can be measured by the different amount of collateral needed to make the senior debt tranche risk-free. In principle, each country could issue senior bonds paying the risk-free rate even under domestic tranching, by posting an adequate amount of collateral. For the Eurozone as a whole, the gain from euro bonds can be measured by the difference between the total cash collateral posted by governments to make their own senior debt risk-free with domestic tranching and the cash deposit needed in the Eurobond scheme. This difference will in general be in favour of euro bonds, because domestic tranching does not benefit from either cross-guarantee or diversification.

How to share this benefit? We answer this question by providing an actuarial method to compute the fair contribution of each country to the cash collateral backing the Eurobond issues, such that cross-country subsidisation would be avoided. This amounts to a very simple rule: Each country should contribute in proportion of the cash deposit that it should post under domestic tranching to make its own senior bonds risk-free.

This rule calls for a larger contribution by high debt countries, which nevertheless might enjoy a lower average cost of debt than what they currently pay. High credit-standard countries should contribute less to the cash deposit. In particular, those that for their reputation (eg Germany) would be able to issue senior debt at the risk-free rate without posting any collateral under domestic tranching, should not bear any additional cost from participating in the Eurobond scheme. In fact, they would already pay their share by contributing the guarantee of their expected primary surplus and so should not be asked to contribute to the cash deposit. In addition, there will not be any additional interest burden for such countries, because they would pay the risk-free rate either issuing domestic debt or euro bonds.

Under the Eurobond scheme, the cost of junior debt would increase, relative to the current cost of debt, by the same extent as with domestic tranching. The lower value of the domestic junior bonds relative to the current market value of public debt could represent a sizeable cost to the private sector. However, this might be mitigated by the incentive to pursue more responsible fiscal policies and to limit the issuance of national bonds, due to the higher marginal cost of debt. Of course, in this regard it is crucial that euro bonds cover only a fraction of government debt, at least for high-debt countries.

A numerical example

Let us conclude with a numerical exercise. Consider the following scenario. The average primary surplus of the Eurozone (as a ratio to GDP) will be 0.9%, with 1.5% standard deviation, over the next 10 years. The growth rate of nominal GDP will be 3%, say 2% inflation plus 1% real growth (a low-growth scenario). Assume a 10-year maturity Eurobond. Our model shows that this bond would have an expected loss of 2.56% (assuming a standard loss given default figure of 60%). If the amount issued is 40% of GDP, then providing insurance to cover this loss would cost little more than 1% of the GDP of the Eurozone. So, if the countries of the Eurozone are ready to post a cash collateral corresponding to 1% of their GDP, issuing euro bonds would certainly be feasible. How to share the cost of this collateral? As we have seen, the rule that we propose is that those countries that more are able to guarantee the bond with their fiscal policy should be required to contribute less in cash. A country whose expected primary surplus is 1.2% of GDP – as opposed to the 0.9% of the Eurozone – would provide less collateral than a country whose expected surplus is 0.6% of GDP, hence the latter would be providing insurance to the former. In this scheme the ‘bad’ country, which receives the benefit of the guarantee from the ‘good’ one, is actually giving back part of this benefit in cash.

References

Baglioni A and U Cherubini (2011), “A theory of Eurobonds”, Working Paper.

Delpla, Jacques, Jakob von Weizsacker (2010), “The blue bond proposal”, Bruegel Policy Brief 2010/03.

Gross D (2011), “Eurobonds: wrong solution for legal, political and economic reasons”, VoxEU.org, 24 August.

Juncker JC and G Tremonti (2010), “E-bonds would end the crisis”, Financial Times, 5 December.

Manasse P (2010), “My name is Bond, Euro Bond”, VoxEU.org, 16 December.

Monti M (2010), “Report to the President of the European Commission”, May.

Suarez J (2011), “A three-pillar solution to the Eurozone crisis”, VoxEU.org, 15 August. 

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Topics:  EU policies Europe's nations and regions International finance

Tags:  Germany, Greece, Eurozone crisis, euro bonds

Associate Professor of Economics, Catholic University of Milan

Professor of Financial Mathematics, University of Bologna

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