Thursday, 7 June 2012

Eurobonds – the idea that just won’t die…

Apart from the lingering debate over a bank recapitalisation fund, European leaders are also kicking the eurobond can around the playground again. So is it feasible?

Little detail has been provided by the proponents of eurobonds on what they might look like. However the most workable form looks to be as follows:

Each country has a ‘eurobond allowance’ as a percentage of their GDP.  This would likely be 60% in order to fit with the Macroeconomic Imbalance Procedure.  Their eurobond allowance would be filled through bonds which are jointly guaranteed by all members.

Source: eurostat, Brewin Dolphin
Thereafter the country may continue to issue national debt which is secured only by itself.  This debt would be ‘junior’ to the eurobond debt (eurobond debts would be repaid before those of national bonds in the event that a country is unable to meet its obligations). 

The resulting multi-trillion euro market of homogenous bonds (covering various maturities) would be expected to provide its underlying issuers with lower borrowing costs than they enjoyed previously.  This is because the larger market would be more liquid (and therefore lower risk) than its ancestors.  Furthermore the last-man-standing guarantee theoretically means that the new market would be stronger than any of its underlying constituents.

Leaving aside the fact that Germany is borrowing for free over two years at the moment (which makes it difficult to argue their borrowing rates will fall), whilst the cost of issuing eurobond debt might fall, the ability of indebted countries to issue national debt would be weaker (because this would now be junior to the mammoth eurobond market).  Most countries, including Germany, could not issue into the eurobond market as most exceed the 60% debt to GDP cap already.

Without a GDP cap on eurobond issuance moral hazard is rife (issuers can load new debts on to their peers), but even with the cap I fear the structure will seem grossly unfair for some members.

Finland, for example, makes up just 2% of eurozone GDP and has very low default risk. For the likes of Germany, France, Italy and Spain, accepting the risk of this mighty-minnow is insignificant.  By contrast for Finland to accept joint liability for a default by Italy, whose GDP is 8 times larger, is unreasonable. 

In case you are thinking the Finns would only be on the hook for their share, then I would remind you that joint liability means any member could be liable for the whole debt.  In case you are thinking that several liability would therefore be more appropriate, as we heard last September, S&P have indicated that this structure would be rated equally to the weakest contributor (which is nonsensical but then that’s rating agencies for you).

But what is so frustrating is that months after the idea was first floated, its impracticality has still not been exposed.

Guy Foster
Head of Portfolio Strategy

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