Everything You Need To Know About The Huge Debate Over Eurobonds

europe summitMany analysts believe that any form of jointly issued European sovereign debt will be unacceptable to Germany. Others are beginning to doubt this.

Photo: Pawelmorski

Eurobonds have come to the forefront of debate over the European sovereign debt crisis today, as investor concerns build about the prospect of a Greek exit from the euro and the outflow of investor cash.Joint guarantees on bonds issued for many or all euro countries have long been considered a compelling—though perhaps impractical—solution to euro debt worries, as it would allow stronger economies like Germany to ensure the debts of the solvent but ever more illiquid Spain and Italy.

Germany has consistently this idea, but now that some EU leaders are finally getting behind some kind of joint bond plan, investors are divided over whether or not they think it will work, and even more divided over whether the eurozone could issue eurobonds in the near- or medium-term.

It’s worth noting that this speculation comes without a detailed plan. The most likely eurobond framework was suggested by the German Council of Economic Experts last November, and this appears to be the plan which investors and politicians are currently considering.

A few details on the plan:

  • It proposes that countries which have not yet received a bailout could pool their debts into a European Redemption Fund, which could issue jointly guaranteed bonds on debts for each country beyond 60 per cent of their GDP.
  • These bonds would be backed by euro member states €2.3 trillion ($2.9 trillion) in gold reserves.
  • Countries using the fund would be forced to adhere to a variety of economic regulations on spending and economic reforms.
  • They would also consent to a European Redemption Pact, outlining how they will lower their gross public debt to 60% of GDP over the next 20 years. After that point, the pact and the joint bond plan would expire.

There is, however, massive disagreement between analysts on if and when this plan would work.

The primary concern is about finding a way to manage the moral hazard of a strong economy like Germany serving as a backstop to the borrowing of its more profligate neighbours to the South.

However, even if you could properly manage this moral hazard by balancing the guarantee structure and the portion of a country’s debt that would be insured by European bonds, some investors are concerned that logistically this plan could destroy already struggling European sovereigns.

Notably, Nomura analysts told analysts in a conference call yesterday that eurobonds could actually be a disaster for the euro area because they would discourage investors from buying the bonds issued by individual countries like Spain (which would finance debts equal to as much as 60 per cent of their GDP) in favour of jointly issued sovereign bonds.

“I can’t stress how bad this is,” Des Supple, the bank’s Global Head of Fixed Income Research, remarked.

Mujtaba Rahman, a Europe analyst for the Eurasia Group, agreed that such a reaction was plausible. “As soon as you create a 2-tier bond structure, it could well make sovereign financing more difficult, which is counterproductive.”

However, others completely disagree. Marc Chandler, the head of Global Currency Strategy at Brown Brothers Harriman, compared the European Redemption Fund program to the U.S. government’s decision to guarantee certain bank debt during the financial crisis, pointing out that in that case the guarantee carried over implicitly to debt not insured by the government.

Similarly, investors would still buy Spanish or Italian debt because issuance of joint eurobonds in the first place would create a backstop on national issuance. “Why pay for an explicit guarantee when there’s an implicit guarantee on other [higher-yielding, national] debt?”

Lombard Street Research economist Dario Perkins took an even stronger perspective, arguing that eurobonds will likely prove the endgame to the crisis. “The only way that this really gets resolved is a proper fiscal union,” he told Buisness Insider. “We’re now at the point where either they will [ultimately] go to fiscal union or fiscal transfers.”

Most analysts consulted by Business Insider admitted that—regardless of their effectiveness—this was not a near term solution, despite recent hubbub.

But Chandler argued that “there’s been a subtle shift over the last 24 to 48 hours” about the likelihood that Germany would consider such a plan in the short term.

He highlighted a recent concession by German Chancellor Angela Merkel and her coalition to meet with the opposition party to discuss the proposal, though both parties ruled out permanent eurobonds. This adds to comments by French President Francois Hollande, Spanish PM Mariano Rajoy, and Italian PM Mario Monti in support of some kind of debt mutualizing plan.

He seemed to be the minority, however.

Clemens Fuest, a senior advisor to the German Finance Ministry, agreed saying, “I think that the situation is very serious really and rather fragile, but I don’t think the situation is serious enough for a radical shift in German government policy.”

Not to mention that the German Constitutional Court could derail the whole project. While the German “wise men” who proposed the deal say its temporary nature might allow it to circumvent rules about surrendering national fiscal sovereignty, experts see opposition to any kind of burden-sharing as high.

But with reports coming in left and right of new consideration and rejection of the European Redemption Fund, this is an issue that’s likely to dominate headlines for the near future.

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