Policy Brief

May 30, 2013

EUROBONDS

Executive Summary The introduction of Eurobonds may provide an effective if still partial solution to some of the major problems that have been raised during the sovereign debt crises in the euro zone. Although it makes some possible suggestions, the most important message from this analysis is that implementation should be the focus for debate. The time has come for Europes political leaders to take a decision about whether t o pursue Eurobonds in principle and to reform all financial sectors.

Nicolae Cebotari

Introduction

Most observers have realized by now that a core problem of the Euro-crisis is the close interconnection between banking and sovereign fragility. The financial crisis, the economic crisis that followed and finally the sovereign debt crisis of euro area member states have revealed shortcomings and deficiencies in the existing governance architecture for economic matters in the EU, and more heavily in the euro area. The economic governance framework has appeared insufficient and inefficient in managing the challenges of the last few years, forcing the establishment or the reinforcing of macro-financial stability (MFS) instruments out of the planned governance structure, especially for the euro area: in the last few years a total of around 680 billion has been mobilised for financial assistance to EU countries in trouble a nd to preserve financial stability and promote the return to sustainable growth in the Union. The need for this level of financial resources was not predicted before the outbreak of the crisis. The Treaty on the Functioning of the European Union (TFEU) foresaw only the possibility of granting Union financial assistance to non-euro Member states (Art. 143), whereas the so-called no bailout clause (Art. 125 TFEU) seemed to prohibit EU assistance to euro area member states (or at least guarantees for their national debts). To provide this level of resources, two channels have been used: EU common MFS instruments. The European Commission, acting in the financial markets on behalf of the EU, manages three assistance facilities, which are the European Financial Stabilisation Mechanism (EFSM) and the Balance-ofPayments (BoP) facility in connection with granting funds to EU member states, and the Macro Financial Assistance (MFA) facility for non-EU countries. MFS instruments of euro area member states. Through the European Financial Stability Facility (EFSF), the 17 euro area member states have established a common fund based on national guarantees for granting funds to euro area countries. The EFSF have been replaced in 2012 with the permanent European Stability Mechanism (ESM).

Why and what are Eurobonds? Eurobonds refer to commonly issued public bonds guaranteed by eurozone countries. The commonly issued debt thus involves the pooling of Member States respective credit risks and guarantees. Weak Member States, in the sense that they are currently facing strong market pressure and high interest rates, would thereby benefit from the credit worthiness and guarantees of strong Member States. Issuance of Eurobonds would likely but not necessarily be centralised in a single European agency. Eurobonds can involve sharing risks rather than sharing a common debt. Each country remains shall liable for repaying its own share of debt issued through Eurobonds. Only if a country fails to meet its payment obligations can creditors call upon the liabilities of other countries. Eurobonds have some similarities with existing forms of jointly guaranteed debt issuances that finance European lending programmes. The Commission already borrows on the financial markets by issuing
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debt that is guaranteed by the EU budget (hence ultimately by all Member States). Moreover, the borrowing operations of the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) are guaranteed by eurozone members. Eurobonds were originally discussed as an advanced form of debt management cooperation offering potential efficiency gains. By integrating the fragmented national public debt markets, Eurobonds higher liquidity would lower the average borrowing cost of the eurozone. As the eurozone debt crisis led to significant and highly volatile interest rate spreads on German bonds, an additional argument in favour of introducing Eurobonds emerged. Common issuance of debt would ease the sovereign debt crisis by providing better market access for vulnerable Member States. The stability of financial institutions would also be reinforced in the short term, as Eurobonds would reduce their vulnerability to volatility in sovereign bond markets. The underlying assumption for the short term introduction of Eurobonds is that countries under market pressure suffer at least to a considerable extent from liquidity problems. Under this assumption, these countries can have structural problems, but are on a relatively sustainable path. Yet, market uncertainty and self-fulfilling prophecies of insolvency force them to pay very high interest rates on their debt. This makes their debt grow fast and can ultimately make it indeed difficult for these countries to reimburse their debt. This would turn the liquidity problems into a solvency crisis. Contagion would in turn amplify the downward spiral, as investors would reevaluate the risk of default of other countries facing similar difficulties. It is important to underscore that Eurobonds neither have a direct impact on current account imbalances and primary deficits, nor on the promotion of growth. Only in their purported capacity of restoring global confidence and stability in the eurozone can they help prevent insolvency and promote growth. Accompanying economic and budgetary policies remain therefore indispensable. Policy recommendations No matter how attractive eurobonds might be as a proposal, there are significant challenges to be tackled before they can be implemented. Hence the basic recommendation is that these implementation challenges should be placed at the forefront of the debate. Considerable challenges wo uld have to be overcome to ensure Eurobonds political, economic and legal feasibility. They involve having adequate control mechanisms in place to address moral hazard concerns, balancing expected economic gains and losses, as well as ensuring Eurobonds legal soundness. The first step could be to harmonize and strengthen the collateral available to banks across the eurozone. This could be done by swapping out the banking books of the panEuropean banking system at par value, using jointly underwritten sovereign debt instruments. For many of the banks, this will insulate them from potential losses like those experienced in Greece as part of private sector involvement. The ECBs exposure to sovereign debt instruments both outright and pledged should be swapped out as well. This will not increase the contingent liabilities of the participating governments. It is already evident from the open sector involvement debate during the second Greek bailout negotiations that these
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assets are effectively senior to those held in the private sector. By swapping them out, the eurozone governments will only make that seniority more explicit. The next step could be to offer distressed countries the opportunity to refinance their debt as it comes due eurobonds in exchange for intrusive auditing and monitoring. This is already happening in those countries that have requested official assistance; it could be made available to all governments in the eurozone on the same conditions. Governments in sound fiscal situations might object that they do not require such supervision; but their demonstration of solidarity would help mollify public opinion in those countries most needing reform. In any event, there would be cost advantages to participating in jointly underwritten sovereign debt issuance, particularly if collateral rules were shaped to privilege these assets for use in obtaining bank liquidity or in clearing. The remaining challenge will be to enforce the thresholds for issuance, particularly for those countries most indebted. The original eurobond proposal was designed to prevent a crisis and not to solve one. Now that it is too late to prevent a crisis, it is probably too soon to unleash market discipline on distressed governments. That said, there is no reason that governments cannot be coaxed back into the markets at some point in the future. Therefore, while it may be necessary to swap out a countrys entire existing stock of debt with eurobonds in the short term, it should be possible to refinance any excess borrowing with strictly national sovereign debt instruments incrementally once the government is able to re-enter the markets. That is essentially what the European bailout mechanisms intend. The financing they provide offers only temporary relief from market pressures and should at some point be paid back as the government regains market confidence. There is no reason that the introduction of eurobonds could not provide similar exceptional and temporary relief. In the final analysis, Europe will have to move to a system that focuses on the borrowing and not the borrower. It will need to stop the geographic flight to quality and it will have to break the strong interdependence between national banking systems and their domestic governments. Otherwise Euro pes policymakers will continue to find themselves periodically descending into crisis. They will overstretch their monetary institutions and may even undermine the eurozone as a whole. These questions are all linked by the structure of the system. The eurozone as a whole needs structural reform.

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