You may recall that, to help inform our response to a consultation from the European Commission on the feasibility of Eurobonds — common issuance of sovereign debt among eurozone members — CFA Institute conducted a poll of its European members in January 2012. While a slight majority believed that eurobonds could help alleviate the sovereign debt crisis, the vast majority was clearly of the opinion that strict preconditions in terms of fiscal, financial, and political integration had to be met for them to be effective, which makes them very unlikely in the short term.
As the debt crisis worsens in Spain and Italy and increases the likelihood of a partial breakup of the eurozone with disastrous consequences, making it necessary for EU leaders to take bold steps to tame it, the discussion on eurobonds comes back to the fore. In that context, a draft report on eurobonds discussed in European Parliament last week describes several steps of a “roadmap” towards the common issuance of long-term eurozone debt. In the short term, though, the draft report urges Member States to seriously consider two tools:
- The immediate issuance of common short-term debt in the form of eurobills
- The immediate set-up of a European Redemption Fund (ERF) that would finance national sovereign debt exceeding 60 percent of GDP
Interestingly, eurobills and the ERF were also recommended as viable short-term tools by Steven Major, CFA, head of global fixed-income research at HSBC, in his last research paper on the subject.
Eurobills would be the common issuance of debt with maturity of less than one year among eurozone members complying with the European Stability and Growth Pact, excluding those undergoing a structural adjustment programme (Greece, Ireland, Portugal, and potentially Cyprus). The European Parliament draft report suggests that eurobills would be issued by a central agency and gradually replace all short-term debt issued by Member States, up to a maximum of 10 percent of GDP, which would represent total issuance of about 900 billion euros. While the European Parliament recommends a “joint and several guarantee” — meaning each participating Member State would be liable not only for its share of liabilities but also for the share of another Member State failing to honour its obligations — Major argues in his paper that it may be possible for it to be just “several,” as the short-term characteristics of bills imply some level of seniority. In terms of pricing, Major estimates that, based on the weighted average of existing eligible bill markets, the yield on a one-year bill would be approximately 50-80 basis points. This would be significantly lower that the current rate paid by Italy and Spain, but still higher than zero — the rate German bills have been paying recently.
The ERF was originally proposed by the German Council of Economic Experts (GCEE), also called the “Five Wise Men”. Like for eurobills, participation in the ERF would be open to all euro-area countries that are not running a structural adjustment programme. Under the ERF, national debt exceeding 60 percent of GDP would be transferred to the ERF, with the rest of government financing needs covered by national issuance on capital markets. This transfer of debt from the national to ERF level would happen over a roll-in phase estimated by the GCEE to last three to five years; as nationally issued bonds come to maturity, the corresponding national financing requirements would be covered by the issuance of ERF bonds. ERF payments made by participating Member States would serve exclusively to repay the debt transferred by this particular country and its related financing costs.
Under the GCEE proposal, the ERF debt would carry a joint and several guarantee from participating Member States. To limit the risk associated with this joint and several guarantee — where participating Member States may be called upon to pay for another country failing to honor its obligations under the ERF — participating Member States would have to earmark/devote part of their tax revenues to the fulfillment of their payment obligations, and deposit collateral, which could be taken from the country’s currency and gold reserves. Participating Member States would also commit to repay their debt exceeding the 60 percent ceiling within a total of 20 to 25 years. This means that participating Member States would have to reduce their debt exceeding the 60 percent ceiling by about 1/20th to 1/25th annually, which would put them in line with the requirements of the EU Stability and Growth Pact and the fiscal compact, signed by 25 of the 27 Member States in March but not yet ratified.
At the end of 2011, the overhang of debt exceeding the level of 60 percent of GDP totaled around 2.3 trillion euros, the lion’s share attributable to Italy (985 billion euros), followed by Germany (580 billion euros), France (498 billion euros), Belgium (136 billion euros), Spain (88 billion euros), Austria (41 billion euros), the Netherlands (24 billion euros), and Malta (0.5 billion euros).
Regarding the yield carried by ERF bonds, the GCEE estimated in January 2012 that, based on prevailing market conditions, it could range between 2.5 and 3.3 percent. Major used a more conservative 4 percent in his June research report, still much lower than yields currently paid by periphery countries (notably Spain and Italy), but about 100 basis points above the yield currently paid by Germany, for example. However, the yield of sovereign debt still issued at the national level would be significantly affected by these new ERF bonds, which would most likely be senior to nationally issued debt, and would therefore have a meaningful impact on the blended yields.
In the current context where the eurozone seems to be on a cliff, and where convincing actions by EU leaders appear increasingly necessary to avoid a breakup, a main advantage of eurobills and the ERF is that they could theoretically be implemented quickly. In fact, they would not require a modification of national law and, in particular, should pass the test of the German Constitutional Court. This is probably why the highly anticipated report of the presidents of the European Council (Herman Van Rompuy), the European Commission (José Manuel Barroso), the Eurogroup (Jean-Claude Juncker), and the European Central Bank (Mario Draghi) that was published earlier this week specifically mentions these two tools: “pooling of some short-term funding instruments on a limited and conditional basis, or the gradual roll-over into a redemption fund”.
However, the report is very noncommittal, so it remains to be seen if a further deterioration of capital markets conditions finally results in more decisive action from European heads of state when they meet this week in Brussels.