Corona bonds – great idea but complicated in reality

Lorenzo Bini Smaghi

Since the outbreak of COVID-19 in Europe, calls have been made by academics, politicians and observers to adopt Eurobonds to finance the actions needed to support economic activity. This column argues that the proposal poses two important political challenges. The first is to promote a broad transfer of economic and social competences from the national to the European level. The second is to reform the European Stability Mechanism and ensure that a sufficient number of countries apply so as to avoid stigma.

Since the outburst of the COVID-19 crisis, Eurobonds have become fashionable again. Calls have been made by academics, politicians and observers to adopt such an instrument in order to finance the actions needed to support economic activity. The term ‘Corona bonds’ has even been coined.

Eurobonds look like a great idea, at least in theory. They would enable European countries to get funds to support increased spending and lower taxes without increasing their national debt.

In practice, however, it’s a bit more complicated. The reason is that the adoption of Eurobonds is not so much a technical decision, which pertains to finance ministers or bureaucrats. It entails a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level. While this may be desirable, it is certainly not easy to achieve in a short time period.

Eurobonds look like are a great idea, at least in theory … In practice, however, it’s a bit more complicated. … entails a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level.

What needs to be made clear is that the attractiveness of any bond issued in the markets depends on its guarantees, which should reassure investors that interest will be regularly paid and that the outstanding debt is sustainable. Public bonds are generally guaranteed by the state’s assets and the ability to generate a sustainable flow of taxation over time. The greater the doubts on these guarantees, the higher will be the risk premium demanded by investors, and thus the yield.

The risk – and thus the interest rate – on the debt of some European countries is higher than others in particular because of the higher level of the debt, the lower rate of growth and possibly also political uncertainties. This may suggest that the risk of a Eurobond would be lower than some of the national debt instruments. There would thus be an advantage in issuing European debt rather than national debt.

Unfortunately, this is not the case, at least in the current institutional environment. Indeed, a Eurobond issued at the EU level, whose proceeds would be distributed to the member states to support their respective budgetary policies, would have a higher risk unless supported by specific dedicated guarantees. There are today no European assets nor European capacity to generate autonomous tax revenues that can be used to guarantee European public debt.

What is needed to issue Eurobonds

In order to issue Eurobonds, the EU needs to be able to generate new fiscal proceeds. The Eurobonds would have the highest credit rating, such as a triple A, only if the EU had direct fiscal authority over the European economy and European citizens.

The easiest way would be to transfer whole parts of the national budgets to the European budget, under the authority of European institutions. For instance, it could be decided that health systems would no longer be under the authority of member states but would become a European competence. Decisions on health issues – hospitals to close or open, salaries, procurement, insurance, etc. – would be decided in Brussels, including overall spending and how to finance it (either through revenues or debt).

Other examples could be offered of which parts of national budgets could be transferred to the European level, providing the latter with sufficient guarantees for raising new debt. These may range from unemployment insurance to general welfare. It means, however, that key decisions such as the retirement age would become a European decision rather than a national one.

This is not an impossible scenario, and it may be a desired one in the view of many. It cannot be ignored, however, that this requires a major transfer of sovereignty that needs to be agreed by all member states. It would be an illusion to think that this would be easy and quick to achieve.

Some have suggested that in order to avoid the problem of the guarantees, Eurobonds should be purchased by the ECB, directly at issuance. This is currently not legally possible. The statutes of the ECB – as is actually the case for most other central banks – do not permit the purchase of government bonds on the primary market. This prohibition aims at avoiding money being used as an undemocratic fiscal instrument to distort market prices. If the central bank purchased a Eurobond at its face value when the market value would be much lower – for instance, because it lacked adequate guarantees – it would incur a loss that would later translate into lower seignorage distributed to its shareholder (i.e. the treasury).

Incidentally, a change in Article 21 of the ECB statutes, which prohibits monetary financing, requires not only the unanimous agreement of the Council but also national ratification by the member states.

To sum up, Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.

The guarantees would be less of an issue if Eurobonds were issued to finance investments, such as European infrastructure, rather than current expenditure. The investments, and their proceeds, would represent the guarantees.

To sum up, Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.

What can be done, instead?

An alternative is to resort to the European Stability Mechanism, which has a triple A rating thanks to its capital basis. The ESM has already issued bonds to finance the adjustment programmes of countries including Spain, Portugal, Greece and Ireland. The ESM could issue an additional €400 billion, and even more if its capital is further increased. The proceeds could then be lent to the member states that apply to the foreseen facilities. This mechanism would not avoid an increase in national debt, but the latter is incurred with the ESM rather than with market investors. The advantages are a lower cost of borrowing and lower risk of illiquidity.

The problem of using the ESM is mainly political. The ESM can grant loans only on the basis of an adjustment programme agreed with the European institutions, which contains a series of conditions. Conditionality can be relatively lighter for the precautionary credit line. However, resorting to the ESM would create a stigma if the number of countries applying is limited. It may signal a fragility to the markets and a relative loss of sovereignty with respect to conditionality, while the crisis is due mainly to exogenous health factors rather than fiscal indiscipline.

The solution would be two-handed. First, conditionality could be limited to an ex-post monitoring of the resources used to address the systemic crisis, as proposed for instance by Olivier Blanchard (Blanchard 2020). This can be done by the ESM governing bodies. Second, several countries could apply simultaneously, to reduce stigma. This would require a sign of solidarity, especially by countries that have a relatively good rating and would not directly benefit from accessing the ESM. The ideal solution would be that all 19 countries apply for the facility, even if they do not draw on it.

This solution would require the pending ESM reform to be adopted by member states, which is currently blocked by Italy over the fear that access to ESM facilities would trigger debt restructuring.

A final issue relates to the interaction between the ESM and the ECB.

Connections between the ESM and the ECB

To be sure, access to ESM is a pre-condition for the ECB to adopt OMT. This means that a country that would use the ESM would also benefit from the umbrella of ‘whatever it takes’, which would probably lead to a reduction of the interest rate spread even without any action being taken by the ECB.

Some suggested that the ECB could also purchase the bonds issued by the ESM in the context of the asset purchase programme, which has been enhanced recently to over €1 trillion.

This would be a mistake, because the bonds issued by the ESM are considered among the safest and are in high demand by investors from all over the world. Their issuance in the market would enhance the international role of the euro. It would thus make no sense for the ECB to create liquidity by purchasing an asset which is itself very liquid. This would not be the best way to counter market instability and to accommodate the appetite for liquidity.

The ECB should rather continue to purchase assets issued by the member states or by private institutions. The ECB has on average bought slightly more than 20% of the countries’ existing debt and is committed to maintain the exposure when maturities expire. It has committed to purchase about another 10%. This significantly reduces the risk of liquidity and sustainability of countries’ debts going forward. It creates room for further fiscal policy action by member states to address the crisis.

Concluding remarks

In conclusion, the debate on the Eurobonds poses two important political choices. The first is to promote a broad transfer of economic and social competences from the national to the European level, which is necessary to give the Union the ability to finance European bonds. The second is to adopt the ESM reform, perhaps by further strengthening its potential with conditionality better calibrated to systemic crises, and to ensure that a sufficient number of countries apply so as to avoid stigma.

The two choices are not necessarily alternative. On the contrary, they can be complementary and carried out with a different time frame. However, they must be made explicitly. Otherwise it is useless, and illusory, to talk about Eurobonds.

References

Blanchard, O (2020) “Italy, the ECB, and the need to avoid another euro crisis”, in R Baldwin and B Weder di Mauro (eds), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, a VoxEU.org eBook, CEPR Press.