Common eurozone bonds – do or die

May 30, 2012

Germany's entrenched resistance to common eurozone eurobonds is under pressure as Spanish and Italian sovereign bond markets nosedive. But there is little consensus on whether this will solve the crisis.

The Italian debt auction disappoints. Spanish sovereign debt yields breach 6.6%, triggering margin call concerns. A comedy of briefing errors sparks market fears over Spanish solvency as officials from the ECB, EU and Madrid lock horns over that controversial Bankia debt-for-equity capitalization plan. Just another ugly day in the eurozone markets. Against this backdrop, a violent panic in sovereign debt markets could be just the jolt Germany needs to flesh out a plan for common eurozone bonds ahead of the end-June EU summit.

For the hawks that tout the cleansing power of balance-sheet recessions and decry intra-regional fiscal transfers, joint eurozone bonds are the stuff of heresy. But in the teeth of the eurozone crisis, action could soon trump such abstract principles – and ultimately prove more palatable for German taxpayers as the contagion spreads.

By delinking national investment decisions from national savings, the systemic risks of running current-account imbalances – and the subsequent risky dependence on foreign capital flows – was always inherent in the eurozone project. The expectation, of course, was that capital would judiciously fund deficits. But the transformation of the eurozone sovereign bond market from a rates market to a credit mart has thrown into sharp relief this structural – and pro-cyclical – flaw.

So enter common eurozone bonds. Right now, it’s Italy and France, principally, lobbying for joint eurobonds versus a nein from Germany, Austria, Holland and Finland. In a September green paper by the European commission, there were three possible approaches, usefully subbed down by Keefe, Bruyette & Woods:

• Approach #1: Joint and several guarantees, all member state debt eventually via Eurobonds .
• Approach #2: Joint and several guarantees, but only partial Eurobonds (suggested up to 60% debt/GDP, called “Blue bonds”), with the rest in national bonds (anything above 60% debt/GDP, called “Red bonds”).
• Approach #3: Several guarantees, with again only partial Eurobonds (i.e. you are only liable for your share of the stability bonds issued, much like how the EFSF/ESM works today).

The results of the consultation were published in May but, as the brokerage notes, at 40, there were a pitiful lack of respondents to the ground-breaking consultation paper, including only six member states and only three banks.

Here are the sub-segment of opinions:

• 9x public entities: three support (European Economic Social Committee, Czech state, French state), six strongly oppose (Danish and Swedish states, plus a joint response from MinFins of Austria, Finland, Germany and the Netherlands).

• 9x institutional investors: broad support, calling it a valuable investment opportunity for a large and liquid market. Approach 2 preferred as gives better moral hazard payoff to ensure high credit quality. Approach 3 almost unanimously rejected. The CFA Institute responded on behalf of 798 individual answers submitted to it, with a preference for approach 2.

• 3x banks. A Dutch bank and a Spanish bank support the idea, whereas a German bank sees Eurobonds as unhelpful. The Spanish and German bank preferred approach 3, whereas the Dutch bank preferred approach 2.

• 2x chambers of commerce: Germany and Austria, both oppose.

• 2 academics: both support

The winds of change in sovereign debt markets might yet overturn this entrenched resistance.

But is the joint issuance of eurobonds – a tentative step towards the creation of a common eurozone sovereign bond market – a necessary but insufficient condition for resolving the crisis? Here’s one view in the negative, from Richard Koo, chief economist of Nomura Research Institute, and a famed balance-sheet recessionista:

While this proposal would rectify one of the eurozone’s two structural defects, it would face large political hurdles and would do nothing to address the second problem.

The two structural defects are (1) the heavily pro-cyclical and potentially destabilizing capital flows among government bond markets that are specific to the eurozone and (2) the Maastricht Treaty’s inability to deal with a balance-sheet recession.

What will happen if Germany, lacking any understanding of balance-sheet recessions, agrees to the joint issuance of Eurobonds under the condition that countries like Spain and Ireland implement additional austerity measures?

The most likely outcome would be that (1) the various financial problems stemming from rising government bond yields – said to be the trigger of the sovereign crisis – would be resolved, but (2) the real economies of these countries would weaken even further as a result of the austerity measures.

The ECB’s two three-year LTROs [long-term refinancing operations] conducted in December and this February helped temporarily lower government bond yields, but yields resumed climbing as market participants began to realize the LTROs would have little impact on the real economy.

Similarly, Eurobonds might lower funding costs for countries in balance-sheet recessions, but there is no reason why the real economy should improve unless their governments are able to borrow and spend more than they are at present.
And if these countries pledge to implement additional austerity measures in exchange for the jointly issued bonds, the resulting deflationary pressures could further exacerbate the recessions.

In that sense, the Eurobond scheme – like the ECB’s LTROs – may have a positive impact on the financial system but is likely to do little for the real economy.

Fair enough. There is a limit to the extent to which common eurozone bonds can fix the transmission channel between reflating the financial markets and thus the real economy - if austerity measures also kick in. That was supposed to be the job of monetary policy and not fiscal policy, after all. In an interview with Euromoney this week, Lorenzo Bini Smaghi, a former ECB official, decried any policy that would see “fiscal transfers from the rest of the union” and that created “incentives for over-indebtedness”.

The consequences of this argument are clear: the destruction of wealth has to be a solution to this crisis so real income streams can service the devalued stock of assets that are left – including government bonds, naturally.

Common eurozone bonds – do or die

Germany's entrenched resistance to common eurozone eurobonds is under pressure as Spanish and Italian sovereign bond markets nosedive. But there is little consensus on whether this will solve the crisis.

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