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Tuesday, July 19, 2011

The name's Bond....Eurobond....

The Economist has an interesting article in this week's edition which partly endorses the idea of 'eurobonds' (although with the qualification that they are politically unworkable right now).

The magazine argues:
"One useful means of allaying the panic might be for euro-zone countries to issue part of their debt as joint bonds. Jointly guaranteed bonds sold to raise money for the current bail-out funds are being eagerly snapped up by investors.

This may make financial sense. But the near-insurmountable obstacle is, as always, political: there is huge resistance to what would become a more overt 'transfer union'. In a group of democracies, where big decisions are taken by unanimity, consensus is hard to come by and takes time. Hence, leaders have acted only in the face of impending disaster, and then with half-measures. Markets operate on a faster timetable. They will not wait for Europe’s leaders, like Churchill’s Americans, to do the right thing after having exhausted all the alternatives."
We would contend that, apart from the obvious drawbacks in terms of democratic legitimacy, the 'eurobonds', at least in their current form, do not represent financial sense either (leaving aside for the moment the fact that taxpayers shouldn't be funding governments they can't democratically control).

The gist of the current proposal is that part of a country's debt would be financed by standard sovereign debt and the rest would be covered by eurobonds, around a 60%-40% split (an idea which has been proposed by Eurogroup chief Jean-Claude Juncker amongst others). However, its highly questionable whether this would be sustainable.

At our debate in London last week, Spanish MP Álvaro Nadal, shadow Economy spokesman for the Partido Popular, which might well be in government soon, commented that "for [Spain] eurobonds would be suicidal" as they would drive up the cost of the nationally financed portion of Spanish debt. He also warned of moral hazard, saying:
"The current eurobonds are very ill-designed. We need a method to encourage fiscal discipline but they are not it".
Handelsblatt economics editor Daniel Goffart made similar comments last December, suggesting that, "On balance, financing costs would not decrease" as the extra risk premium (higher interest rate) which investors would want on the nationally denominated debt, would outweigh the savings from the lower borrowing costs on the eurobonds. And it would not only be struggling eurozone countries that would see higher national borrowing costs, but also the likes of Germany, who would be explicitly guaranteeing eurozone debt, via eurobonds. Investors would be likely to demand a premium for this potential additional burden on Germany's national finances.

There's also the fear that this proposal puts the eurozone on a slippery slope. Once some debt is guaranteed by everyone and the cost of financing national sovereign debt starts increasing, there could be calls for a larger and larger percentage of debt to be in the form of eurozone-guaranteed eurobonds. Some might say this is a speculative fear but, given where we are now after the original bailout decision, it's clear that nothing should be unthinkable when it comes to the eurozone.

Last but not least, there is also the concern that eurobonds are, in fact, illegal under the EU treaties. Such fleeting issues have been circumvented in the past (bailouts), but it may be even more overt this time around. German Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble have already made strong statements on this topic. They were backed up this weekend by Bundesbank President Jens Weidmann.

Last December, Merkel made her position perfectly clear saying:
"It is our firm conviction that the treaties do not allow joint eurobonds, that is no universal interest rate for all European member states. Competition on interest rates is an incentive to respect stability criteria."
Although we all know that similar comments were made in regards to the bailouts, we hope Merkel and her government have learnt some lessons over the past year about how some decisions can snowball and take you to a place you don't necessarily want to go (second bailout, talk of permanent fiscal transfers, political unrest, a central bank bleeding credibility etc etc).

We don't think eurobonds will be on the table at this week's summit but expect the debate to continue back and forth in the weeks and months to come.

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