No. 2 No. 10 June 2011 June 2012

A Briefing on Eurobonds

Xavier Vanden Bosch & Stijn Verhelst

The briefing firstly discusses the reason why The recurrent debate on Eurobonds are considered in the current Eurobonds is often clouded by policy debate (part 1). Subsequently, the misconceptions. This Policy Brief concept is defined, as well as its clarifies their aims and possible main design options (part 2). The key forms, before discussing the key economic, political and legal challenges for challenges for their introduction. It their introduction will be discussed argues that, by ensuring market afterwards (part 3). Finally, possible next access to vulnerable Member steps, reconciling the different views on the States, Eurobonds can constitute a timing and conditions to be met, will be valuable tool to alleviate the discussed in part 4. crisis. To make use of their short-term potential, a condi- 1. Why Eurobonds? tional and progressive introduction of Eurobonds, starting with a Eurobonds were originally discussed as an limited scheme, seems the best advanced form of management achievable approach. cooperation offering potential efficiency gains1. By integrating the fragmented national public debt markets, Eurobonds’ higher Introduction liquidity would lower the average borrowing cost of the eurozone. Ideally, Lively discussions on Eurobonds resurface rivalling US Treasury Bonds in their ‘safe- whenever the outlook on the eurozone’s haven’ status, Eurobonds would furthermore future seems to worsen. The term promote the role of the as a reserve ‘Eurobonds’ refers to common issuance of currency. debt among eurozone countries. However, as As the eurozone debt crisis led to significant the concept of Eurobonds is vague, public and highly volatile rate spreads on debate is often clouded by confusion on the possible aims and forms of such instruments. 1 Giovanni Group (2000), Report on co-ordinated issuance of public debt in the euro area.

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German bonds, an additional argument in 2. The ‘Eurobond’ concept favour of introducing Eurobonds emerged. Common issuance of debt would ease the 2.1. A definition of Eurobonds sovereign debt crisis by providing better ‘Eurobonds’ (or ‘stability bonds’ in the market access for vulnerable Member States. Commission’s wording) refer to commonly The stability of financial institutions issued public bonds guaranteed by would also be reinforced in the short term, as eurozone countries. The commonly issued Eurobonds would reduce their vulnerability debt thus involves the pooling of Member to volatility in sovereign markets. States’ respective risks and guarantees. The underlying assumption for the short- ‘Weak’ Member States, in the sense that they term introduction of Eurobonds is that are currently facing strong market pressure countries under market pressure suffer - and high interest rates, would thereby benefit at least to a considerable extent - from from the credit worthiness and guarantees of liquidity problems. Under this assumption, ‘strong’ Member States. Issuance of these countries can have structural problems, Eurobonds would likely – but not but are on a relatively sustainable path. Yet, necessarily_– be centralised in a single market uncertainty and self-fulfilling European agency. prophecies of force them to pay Eurobonds involve sharing risks rather very high interest rates on their debt. This than sharing a ‘common’ debt. Each makes their debt grow fast and can ultimately country remains liable for repaying its own make it indeed difficult for these countries to share of debt issued through Eurobonds. reimburse their debt. This would turn the Only if a country fails to meet its payment ‘liquidity’ problems into a ‘solvency’ crisis. obligations (i.e. it defaults) can creditors call ‘Contagion’ would in turn amplify the upon the liabilities of other countries. downward spiral, as investors would re- evaluate the risk of of other countries Eurobonds have some similarities with facing similar difficulties. Consequently, existing forms of jointly guaranteed debt current sovereign bond spreads would be issuances that finance European lending explained, to a significant extent, by programmes. The Commission already ‘mispricing’ due to unwarranted risk borrows on the financial markets by issuing aversion and/or herd behaviour among debt that is guaranteed by the EU budget investors. (hence ultimately by all Member States)2. Moreover, the borrowing operations of the It is important to underscore that European Financial Stability Facility (EFSF) Eurobonds neither have a direct impact and European Stability Mechanism (ESM) on current account imbalances and are guaranteed by eurozone members. 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. 2 These borrowing operations are used for Balance of Payment Support, the European Financial Accompanying economic and budgetary Stability Mechanism (EFSM) and Macro-financial policies remain therefore indispensable. Assistance Programmes.

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Eurobonds should, however, not be the remaining national debt issuances proves confused with ‘project bonds’, which are ‘excessive’, Eurobonds’ objectives of fundamentally different instruments; ensuring the borrowing resilience of ‘weak’ project bonds benefit from European countries and preventing contagion would guarantees, but are issued by companies. not be met. They further aim at facilitating the financing of specific infrastructure projects rather than Guarantee structure general government expenses. With ‘proportionate guarantees’ (also 2.2. Key Eurobond design options referred to as ‘pro-rata’ or ‘several’ guarantees) each guaranteeing Member The many conceivable types of Eurobonds State is only liable for its share of can be defined by some key characteristics. Eurobonds liabilities. Liability would be based on a specific contribution key, which Size of the Eurobond market can, inter alia, be based on the Member States’ share in issued Eurobonds, ECB capital, EU The size of the Eurobond market will depend budget or GDP. The EFSF and the ESM on the degree of substitution of national function on this basis. debt issuances by Eurobonds. With full substitution, national debt issuances are With ‘joint and several guarantees’, each discontinued and country is liable not only for its own share financing is entirely covered by of Eurobond issuances but also for the Eurobonds. In addition, past national debt share of any other Member State failing to could possibly be exchanged for Eurobonds. honour its obligations. Such a form of guarantee would in theory be stronger than a With limited substitution, national debt ‘proportionate’ guarantee and would thus issuances continue to exist along lower Eurobond borrowing costs. Eurobonds. A ceiling, expressed in relative terms, is generally used to determine the If needed, the Eurobonds’ guarantee can volume of debt that can be financed with be enhanced by other means. This can Eurobonds (e.g. relative to a country’s GDP). involve legal seniority status (over national If recourse to the Eurobond scheme is not debt issuances) or collateralisation (with mandatory, some ’strong’ countries would cash, gold, shares of public companies, likely finance themselves exclusively through earmarking on fiscal revenues, etc.). their national bonds. This might lower the credit rating of Eurobonds, as only ’weak’ Conditionalities countries would issue debt through Eurobonds. Participation of a Member State to the Eurobonds’ issuances can be made Under the limited substitution option, debt conditional on meeting specific criteria financing beyond the limit set on Eurobonds and/or the agreement by other would be financed by national debt. The participating countries. Specific criteria attached guarantees would - at least de facto could, for example, involve meeting strict but possibly de jure - make Eurobonds senior fiscal and macro-economic thresholds, to national bonds. If the market pressure on having adopted binding fiscal rules and not

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being engaged in an EU/IMF adjustment 3. Challenges to the introduction of programme. Besides specific criteria, Eurobonds participation in Eurobonds can also be conditional on the consent of other eurozone Considerable challenges would have to be countries and perhaps the Commission. overcome to ensure Eurobonds’ political, economic and legal feasibility. They involve Main proposals having adequate control mechanisms in place The three most often cited proposals involve to address concerns, balancing limited substitution of national debt and expected economic gains and losses, as well ‘joint and several’ liability, with a varying as ensuring Eurobonds’ legal soundness. degree of conditionality. 3.1. Economic Union and moral hazard Firstly, the Blue Bond proposal would considerations replace up to 60% of GDP of national debt Despite their inconsistent and possible by Eurobonds, with the residual debt currently excessive disciplining effect, remaining national. The right of Member markets have demonstrated some efficiency States to issue Eurobonds would depend on at incentivising Member States to correct their compliance with the EU’s fiscal rules. fiscal deficits and economic imbalances. The Secondly, the Redemption Fund proposal major and most often heard argument against would bring together all national above Eurobonds is therefore that by removing the the 60% of GDP threshold into one fund. discipline imposed by markets on Debt in this fund would be financed by governments, Eurobonds would create so- Eurobonds. Member States would then be called ‘moral hazard’. Governments obliged to redeem (i.e. reduce to zero) their benefiting from lower yields might have part of the fund within a 20-25 year the incentive to run inappropriate policies timeframe, after which the fund would leading to (further) public debt concerns and expire. a lack of economic competitiveness; the negative consequences of which would Finally, the Euro-bills proposal would ultimately be borne by others. With introduce common debt issuances with a Eurobonds, the stronger the insurance short-term maturity (one year at most), which provided to ‘weak’ countries - through the would then co-exist with long-term national guarantees, collaterals, and credit worthiness debt. Under the proposal, the size of the of ‘strong’ countries - the stronger the moral Euro-bills market would be 10% of GDP at hazard issue. most3. This trade-off between insurance and moral hazard is inherent in any insurance scheme. Taken too strictly and given the safeguards already provided by the revised

3 See ‘Blue Bond/Red Bond’ proposal (Delpla – EU economic governance framework, the von Weizsacker, 2010), the ‘Redemption Fund’ moral hazard argument can tend to proposal (German Council of Economic Experts, exaggerate the drive towards deficits and 2011) and the ‘Eurobills’ proposal (Hellwig – Philippon, 2011). debt. Yet, to manage concerns and ensure political feasibility, any Eurobond

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introduction would need to compensate for the lower the interest rates asked by this alleged reduction of discipline by other investors. Liquidity gains due to the larger mechanisms. size of the Eurobond market can be expected, but should, however, be quite Different solutions are possible. In general, limited4. Perhaps most significantly, by stronger disciplining mechanisms and providing affordable interest rates to ‘weak’ safeguards within a reinforced Economic countries, current excessive mispricing due Union could pre-condition the introduction to speculation and market uncertainty of Eurobonds. Solidarity implied by would be limited, thereby significantly Eurobonds would come with better control lowering the average funding cost of the of fiscal and macro-economic imbalances. eurozone5. This control is subsequently difficult without some political accountability. Steps towards a However, even when benefiting from ‘Political Union’ would in turn be necessary. important absolute gains, Eurobonds’ levels would likely still lie higher than the In order to reduce moral hazard, the current very low bond yields in Germany Eurobonds’ design could also limit the and other triple-A Member States. The lower benefits obtained by ‘weak’ Member interest rates that would be obtained by States. Member States could be required to countries currently under financial market partly finance themselves with national debt, pressure would thus come at the expense of which would allow for market scrutiny of the most creditworthy countries. Eurobonds individual Member States. Alternately, the would thus, indirectly, result in transfers benefits of Eurobonds could depend on a from ‘strong’ to ‘weak’ eurozone Member State’s credit worthiness or their countries. The scale of such solidarity is respect of the economic governance rules inherently uncertain, as it depends on the (see 2.2). If properly designed, yields of future Eurobonds. conditionalities might not only be able to reduce moral hazard, but could also become However, the losses for creditworthy a driver for better fiscal and economic countries can be compensated. One policies. option to work towards a ‘win-win’ situation is to redistribute the gains and costs of 3.2. Economic considerations Eurobonds. By assigning different interest rates to each country, reflecting their relative Eurobonds would make economic sense performance, ‘winners’ of the scheme (e.g. if they were to lower the global average Spain) would compensate ‘losers’ (e.g. borrowing cost of eurozone countries, i.e. if the of Eurobonds is below the weighted average of participating countries’ 4 Were it to reach the size of the US government , one could expect rather limited gains, current interest rates. estimated between 10 and 20 basis points according to the Commission. See: Green Paper on the The extent to which investors will value feasibility of introducing Stability Bonds, European Eurobonds below this weighted average Commission, COM(2011) 818. 5 depends on several factors. The stronger Again this expected gain crucially depends on the interpretation of the causes of the crisis, and of the the guarantees and other collaterals, the interpretation of spreads divergence. See Part 1 on lower the perceived risk of default and hence the rationale for Eurobonds.

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Germany). Such a compensation scheme Member States from assuming EU would, however, not work if Eurobond yields commitments. Therefore, an EU body could are too high. The Eurobond scheme could be legally responsible for repaying also be limited in time and volume, in order Eurobonds, while Member States would in to cap the level of solidarity. turn guarantee the EU body’s financial obligations. Alternatively, Eurobonds could A broader perspective on relative costs be defined as a specific project, for which the and gains would also help to reach a no-bailout clause provides an exception. consensus. In particular, this could involve the acknowledgment that extremely low Working around the no-bailout clause is interest rates in core eurozone countries are likely to leave some legal uncertainty, an partly resulting from the crisis itself, as capital option that creditworthy countries seek to flight from the riskier periphery to the safer exclude. Eurobonds could therefore core takes place. More generally, the political necessitate a modification of EU primary feasibility of issuing Eurobonds will depend law, or at least the commitment to do so in on ‘strong’ countries’ own perception of the the near future. Making use of the simplified risks and costs associated with a protracted revision procedure is conceivable, but would crisis, possible additional bailouts and/or a still require ratification in all Member States. break-up of the eurozone. The procedure can furthermore not lead to an increase in the EU’s competences and 3.3. Legal considerations would hence likely lead to an intergovernmental approach. The alternative The legal problems related to the is a full-blown Treaty reform. This tends to introduction of Eurobonds depend on the be a drawn-out process, but can be specific design. Ensuring the legal accelerated if needed. compatibility of Eurobonds benefiting from joint and several guarantees would be Besides the legal issues on the EU level, more challenging than Eurobonds with Eurobonds also pose problems with ‘proportionate’ (i.e. not joint) guarantees, regard to German law. The German as the former imply a greater level of risk- Constitutional Court ruled that the country sharing. cannot participate in a permanent mechanism in which it assumes the liability for other On the EU level, the no-bailout clause Member States' voluntary decisions. (Article 125(1) TFEU) constitutes the prime However, the Court’s verdict leaves some legal obstacle. The clause prohibits the EU room for Eurobonds, as long as the German and the Member States from assuming the liability is precise, limited in size, and subject financial commitments of (other) Member to regular approval by the German States. Yet, Eurobonds would precisely imply Parliament6. that Member States agree to take over the commitments of other Member States when needed.

Policy-makers can try to work around the restrictions of the no-bailout clause. 6 Federal Constitutional Court of Germany, Ruling Firstly, the clause does not prevent the of 7 September 2011, Case 2 BvR 987/10.

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4. Steps towards Eurobonds towards an Economic and Political Union and a fully-fledged system of Eurobonds. Major differences exist among Member States on if, how and when Eurobonds Conclusion should be introduced. Especially the timing is a matter of vivid disagreements. So far, the EU has proven ineffective at managing the risk that self-fulfilling Some advocate the short-term introduction prophecies of insolvency lead to an of Eurobonds. Such a move would be of unsustainable rise in a Member State’s major use in addressing the ongoing crisis, borrowing costs. The limited size and strong although it would be difficult to address all conditionality of the assistance mechanism the aforementioned challenges. Despite the (EFSF/ESM) constrains its capacity at potential advantages, the prompt preventing this risk. As for the ECB’s introduction of Eurobonds seems politically reluctant interventions, they have shown their difficult. limits in restoring confidence and cannot substitute for a coherent and concerted On the other end of the spectrum is the idea political response to the crisis. The lack of an of introducing Eurobonds as the adequate response to the intensifying liquidity conclusion of an Economic and Political problems further aggravates the crisis and Union, requiring long-term reforms. This increasingly puts the sustainability of the approach is politically the most feasible. Yet, common currency into question. the mere agreement on a possible introduction of Eurobonds in the long term Eurobonds can be part of a comprehensive will not help address the ongoing crisis. response to the crisis. They can help ‘weak’ Member States retain access to financial Given the limits of both the short-term and markets. This would in turn improve their long-term views, a precise roadmap outlook and reduce the risk of contagion to emerges as the best achievable option. other Member States. However, eurozone Such a roadmap would include a timeline and countries would still crucially need to address conditions for a gradual introduction of the root causes of the crisis, i.e. unsustainable Eurobonds. A first tangible step could fiscal policies and/or major economic consist in a pilot project whose limited size, imbalances. Yet, Eurobonds would offer the guarantees and/or maturity would reduce time and means to carry out the necessary concerns linked to Eurobonds7. By offering a reforms. Moreover, participation in limited short-term alternative source of Eurobond issuances could be made financing to countries under market pressure, conditional on compliance with European it could prove useful in mitigating the current economic governance rules, thereby crisis. If the pilot project were to have supporting the implementation of these rules. encouraging results, it would pave the way Despite the immediate advantages of 7 Such a roadmap could include elements of the draft report by the European Parliament, although Eurobonds, the political feasibility for their other options are also conceivable (notably a reform swift introduction seems limited. However, if of the ESM). See: European Parliament, 2012, Draft Eurobonds were only to be considered as a report on the feasibility of introducing Stability long-term possibility, when an eventual Bonds, 2012/2028(INI), 4 June. Economic and Political Union is achieved,

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their potential at restoring confidence in the Stijn Verhelst is Senior Research Fellow at eurozone would be lost. Egmont - Royal Institute for International Relations Taking into account the limits of both the The authors thank the various experts who short-term and the long-term perspectives, commented on an earlier draft of this brief for the best achievable outcome is a gradual their valuable input. approach. This should consist in the commitment to work out a clear, conditional

Eurobonds roadmap, whose most immediate The European Policy Brief is a publication of Egmont, step would consist in a limited Eurobonds the Royal Institute for International Relations scheme. Such a scheme should allow for EGMONT affordable market access to countries under Royal Institute for International Relations financial market pressure, while Naamsestraat 69 simultaneously not stretching solidarity 1000 Brussels beyond what is deemed acceptable given the BELGIUM current state of economic and fiscal > www.egmontinstitute.be integration. The opinions expressed in this Policy Brief are those of the Xavier Vanden Bosch is Research Fellow at authors and are not those of EGMONT, Royal Institute for Egmont - Royal Institute for International International Relations Relations.

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