A realistic Eurobond proposal

Posted by on 20 September 2011

The creation of a European bond has been proposed as a silver bullet for the ongoing sovereign crisis. The idea that a “common bond” could in itself sort out the mess of certain Euro Member States is in itself erroneous and dangerous in addition to being unrealistic from a political standpoint. The birth of a common market could be an advantage for all, provided that a form of strong fiscal coordination among Member States is created. Unfortunately, Europe does not seem to be equipped with an institutional framework able to make budget commitments credible and at the same time it does not appear ready to sacrifice national sovereignty to centralize national fiscal policies. Overall, even only a minimum amount of realism suggests that Eurobonds cannot transfer the burden of public debt from the less virtuous countries to the most thrifty. So what is in this scenario the role of an European bond? There are a couple of reasons often undervalued:

1.     

It should insulate systemic risks from the sovereign bond market. A default even by a small Member State has now ripple effects throughout the entire financial market. An European bond should be engineered to foster the containment of domino effects.

2.     

It may represent an opportunity for a greater integration of fiscal policies. The conditions set for accessing the “common market” should ensure the fiscal discipline that the Stability and Growth Pact failed to accomplish.

3.     

The debate may have the effect of reassuring the market on the whole euro project. The message given to the market would be that of irrevocable choices towards a greater political and economic integration.

Far from sparing us a painful budget policy and the adoption of growth stimulating reforms, the creation of a “limited but irreversible liability company” probably represents the maximum one can aspire to at this stage. Here is a proposal.

The Euro Area Member States found an agency, the European Debt Management Agency (EDMA), in charge of issuing and managing the European Public Debt. The agency is endowed with a capital (around EUR 80 Bn) underwritten by all Member States in proportion to their GDP. The EDMA issues bonds in its own name and lends to Member States in proportion to their capital in the EDMA and up to the 60% of their GDP.

Membership in the EDMA is irrevocable, as well as the status of guarantor of bond issues: each member guarantees pro quota the sum of all Agency issuances without possibility of opting out at a later stage (No Opt Out Clause).

The launch of the Eurobond (EB) would determine a segmentation of the government bond market. To ensure an adequate level of liquidity within a short time and avoid the possibility of a crowding-out effect, (gross) bond issues of individual member states would be limited in the initial phase. Bonds issued in the name of member countries after the birth of the Eurobonds would be subordinated to EDMA lending, whereas the stock of the pre-existing debt would continue to enjoy the same level of seniority.

The commitment of every Member State to guarantee pro quota (Several Guarantee) for all bond issued should have more credibility on the market than a scheme requiring a Joint and Several Guarantee. The assumption that the latter necessarily leads to greater credit enhancement is based on the fact that it would determine a lower probability of default. Indeed, in the absence of limits on responsibility (Liability Cap) a guarantee of this type risks to have little credibility without considering that it could also impact very negatively the rating of the Member State.

In order to obtain a triple A and insulate it from the rating of individual Member States, the EDMA should be supported by an over-guarantee and by other credit enhancements. An over-guarantee of 150% of its capital key by each Member State and a cash buffer of 15% for only non-triple A Member States. For instance each non-triple A State could obtain EUR 85 in financing for each EUR 100 in Eurobonds, the remaining EUR 15 would be deposited in an ECB account. The overcollateralization system, the cash buffer and the seniority status of the loans will allow the EDMA’s rating to be stabilized, reducing the effects that possible downgrades of guarantors could have on the funding cost. The quality of the asset is the first and most effective guarantee of rating stability. Not only the seniority attributed to the lending but also the process for access to Eurobonds should guarantee the solvency of the Agency over time.

The return from investing these funds could also be used to reduce the cost of financing of the triple A countries. To EDMA capital should strengthen further EDMA’s credit worthiness and the capability to subsidize the most fiscally virtuous Member States. According to our calculations, at the time of writing the EDMA would have available approximately EUR 7Bn yearly to distribute among triple A countries to reduce their financing costs. This should not only be an incentive for countries with the highest credit worthiness to participate in the scheme, but it should also produce an additional incentive for less virtuous participants to carry out a convergence toward more sound policies. 

Adopting a flow based approach, Member States would be required to finance part of their own gross borrowing through the EDMA. Annual targets may be agreed upon with the European Commission and linked to the presentation of the Stability plans.

The absence of an opt-out clause is specifically directed toward greater involvement of all participants and towards a balanced system of guarantees. At any time EDMA will have a credit exposure toward each Member State proportional to the underwritten capital and the provided guarantees.

At the very beginning of the EDMA operations the smallest and most indebted Member States will derive the most benefit from it. On the other hand this should not be surprising. In the same way as the creation of ECB allowed the interest rates of the various countries to converge toward the German ones, an European debt agency could also be the operating instrument for fostering a convergence of public finances in the Euro Area.