High public debt, even if sustainable, makes the debtor countries and their neighbours financially vulnerable. In many countries in the euro area, the past 10 years have been marked by a double-dip recession, with high public debt as its legacy.
Above a certain level of indebtedness sovereigns are exposed to abrupt liquidity crises and investor scepticism can lead to self-fulfilling expectations of default, even when those countries are fundamentally solvent (Calvo 1988, Cole and Kehoe 2000). Also, during the sovereign crisis we saw contagion and increased interdependence. After the adverse fiscal developments in Greece, funding costs in other periphery countries were affected more than would have been justified by their fundamentals (Giordano et al. 2013, De Grauwe and Yi 2013, Favero and Missale 2012 and 2017). All periphery countries suffered from market fears of a euro break-up, from a more constrained environment for monetary policy, and from trade and financial portfolio spillovers. The consequences of contagion are magnified when there are multiple equilibria, because tensions in one country can trigger negative self-fulfilling expectations in another one.
The problem of high debt should be addressed by maintaining adequate primary surpluses over a sufficiently long horizon. But fiscal prudence by itself is likely to take a long time to significantly reduce debt. Meanwhile, the euro area would risk a systemic crisis due to adverse equilibria in one or more high-debt countries. As ECB President Mario Draghi said in 2018:
“Without appropriate backstops at the euro area level, individual countries in a monetary union can be exposed to self-fulfilling dynamics in sovereign debt markets”
(Draghi 2018).
Design of debt redemption funds
A European debt redemption fund (ERF) may provide this backstop. This involves pooling part of national debts in a common refinancing tool. The Fund is designed to be temporary. Resources for debt rollover and redemption would come from the participating countries, which would either transfer assets or channel a stream of income to the Fund.
Proposed schemes include mutual insurance and risk sharing, but differ along several dimensions:
- the amount of the initial debt transfer, and whether it is transferred gradually or instantaneously,
- the timespan of debt redemption,
- the determination of resources assigned to the ERF,
- the provisions of explicit or implicit transfers among countries,
- possible accompanying mechanisms to tackle moral hazard.
Table 1 Main previous proposals1
Our proposal
In a recent paper (Cioffi et al. 2019) we list our guiding principles to implement a redemption fund as an (implicit) insurance scheme. In our view, an ERF is not meant to improve debt sustainability (which should be a precondition for joining the scheme). It should not involve explicit or implicit systematic transfers from low-yield to high-yield sovereigns (not to impair political feasibility). Its financing should have counter-cyclical properties, making the debt redemption effort less burdensome in hard times. In practice, the ERF could function as follows:
At launch, each participating country would transfer to the ERF a share of its public debt. This amount can differ across countries, but ideally it should be large enough to make the residual national debt no longer 'systemic'. The transfer and its swap into new 'ERF debt' should be instantaneous, so as to minimise the risk of financial tensions.
Each country commits to a yearly country-specific payment to the Fund. The payment is a time-invariant share of annual GDP such that the expected value of the future stream of payments equals the expected value of interest spending that the country would have paid on the transferred debt, if the scheme had not been introduced.
ERF solvency is ensured as long as:
1. GDP evolves in line with the forecasts made at the launch, and
2. the ERF issues bonds at a rate equal or lower than the expected weighted average of national issuing rates.
Of course, errors in forecasts are likely. If a country's GDP or the ERF’s interest rates evolve more favourably than forecasted, the ERF’s debt would be redeemed faster than expected. In the opposite case, there must be adequate adjustment mechanisms. Specifically, we propose that every T years, country-specific transfers are re-set as necessary.
The ERF’s sustainability is guaranteed, because any discretionary fiscal policy is ruled out. The only activity of the Fund would be to pay interest and gradually redeem debt.
Country-specific transfers can be computed to rule out ex-ante systematic transfers between countries. Because they are time-invariant as a share of GDP, they are counter-cyclical. If GDP grew faster than forecast in any year, the absolute value of the payment to the ERF in that year would be larger than expected. If GDP were to grow more slowly, then the national transfer to the ERF in that year would be smaller.
So maybe in one year one country pays more than expected, while another country pays less, because their economic cycles have diverged. In this case there would be an implicit transfer between the two, but this would not be systematic. It would be compensated as relative cyclical conditions change. The periodic reassessment of country contributions would also account for systematic deviations, and possibly compensate any slippages that have occurred in previous periods.
Main advantages
The benefits of our scheme are strictly related to the insurance features that it introduces in the euro area.
High-debt countries. It sets an upper limit to the interest rate on a large share of debt – as long as the ERF can issue bonds at a rate no higher than the weighted average of national rates, no risk of rising spreads and no risk of rollover will weigh on the mutualized debt. The counter-cyclicality of the transfer scheme provides an insurance against unfavourable economic developments.2
Low-debt countries. These countries are insured against the risk of fiscal profligacy in their high-debt counterparts. Should sovereign yields drop after the introduction of the ERF, high-debt countries would continue to pay up to the periodical revision as if their average cost of debt was unchanged. To the extent that the reduction in sovereign yields is mirrored also in the ERF interest rates, this would speed up the redemption of the mutualised debt. Second, a share of national tax resources would be earmarked for the ERF – in the same way as the share of national VAT is currently transferred to the EU budget – and by construction this is for debt reduction. This enhanced commitment is because the ERF is an international compact ,and could not be achieved by a country in isolation.
Even after the introduction of the ERF, member countries would still manage a non-negligible amount of national debt. To avoid moral hazard, the ERF might be complemented with more stringent and automatic fiscal rules. Once remaining national debts are no longer financially systemic, the no-bail-out clause would become more credible, and markets would be more effective in imposing fiscal discipline.
As an example, in our paper we assume that the four largest euro area countries take part in the ERF. We show that, under reasonable macroeconomic and fiscal assumptions,3 country-specific contributions to the ERF would range from 1% to around 2% of GDP. ERF debt would steadily decline from 60% of the area GDP to below 20% in 30 years. Assuming compliance with European fiscal rules, the residual tranches of national debts would also decline. Total sovereign debt of the area (ERF and national) would decrease from around 90% to 30% of GDP in the same timeframe (Figure 1).
Figure 1 Projected debt dynamics of an ERF for the four largest euro area countries (% of euro area GDP)
Source: Cioffi et al. (2019)
Possible ways forward
While our ERF is aims at debt reduction, it is a flexible mechanism which can be used to implement further reforms in the euro area. In particular:
- ERF bonds are by construction temporary (the ERF is bound to redeem its debt in full) but the mandate of the ERF could be changed to stop redeeming debt once it reaches a given threshold, and simply roll it over. ERF bonds could then become the safe asset that is currently missing in the euro area.
- Once debt has been sufficiently reduced, countries may also decide to change the nature of the ERF budget and use it as a full-fledged common fiscal capacity to improve fiscal stabilisation in the euro area. They could do this without having to agree on a fiscal union.
- Once the ERF is fully operational and national debts are sufficiently reduced, there would no longer be a threat of unfavourable market reactions, and so it would be possible to reform the prudential treatment of banks’ holding of sovereign bonds may be considered, or introduce a sovereign debt restructuring mechanism (Committeri and Tommasino 2018).
References
Cioffi M, M Romanelli, P Rizza and P Tommasino (2019), "Outline of a redistribution-free debt redemption fund for the euro area", Bank of Italy occasional papers 479.
Committeri M and P Tommasino (2018), "Managing sovereign debt restructurings in the euro zone. A note on old and current debates", Bank of Italy occasional papers 451.
Corsetti G, L P Feld, P R Lane, L Reichlin, H Rey, D Vayanos and B Weder de Mauro (2015), A new start for the Eurozone: Dealing with debt, CEPR Press.
Corsetti G, L P Feld, R Koijen, L Reichlin, R Reis, H Rey, and B Weder di Mauro (2016), Reinforcing the Eurozone and Protecting an Open Society, CEPR Press.
De Grauwe P and Y Ji (2013), "Self-fulfilling crises in the Eurozone: An empirical test", Journal of International Money and Finance 34(C): 15-36.
De Grauwe P and W Moesen (2009), "Gains for All: A Proposal for a Common Eurobond", Intereconomics 44(3): 132-135.
Dosi G, M Minenna, A Roventini and R Violi (2018), "Making the Eurozone Works: A Risk-Sharing Reform of the European Stability Mechanism" (available at SSRN: https://ssrn.com/abstract=3208267 or http://dx.doi.org/10.2139/ssrn.3208267).
Draghi M (2018), "Europe and the euro 20 years on", speech at Laurea Honoris Causa in Economics by University of Sant'Anna, Pisa, 15 December.
Favero C A and A Missale (2017), "Contagion in the EMU. The Role of Eurobonds within OMTs", Review of Law and Economics 12(3): 555-585.
Favero C A and A Missale (2012), "Sovereign spreads in the Euro Area: Which Prospects for a Eurobond?" Economic Policy 70: 231-273.
German Council of Economic Experts (2011), Assume responsibility for Europe, Annual Report 2011/12.
Giordano R, M Pericoli and P Tommasino (2013), "Pure or Wake-up-Call Contagion? Another Look at the EMU Sovereign Debt Crisis", International Finance 16(2): 131-160.
Minenna M and D Aversa (2018), "A Revised European Stability Mechanism to Realize Risk Sharing on Public Debts at Market Conditions and Realign Economic Cycles in the Euro Area", Economic Notes 48(1).
Parello C and V Visco (2012), "The European Redemption Fund: A Comparison of Two Proposals", Politica Economica 28(3): 273-306.
Pâris P and C Wyplosz (2014), PADRE: Politically Acceptable Debt Restructuring in the Eurozone, Geneva Special Report on the World Economy 3, ICMB and CEPR.
Endnotes
[1] De Grauwe and Mosen (2009) propose a scheme of Eurobonds in which countries’ payments are based on their own sovereign debt cost so excluding implicit transfers. Minenna and Aversa (2018) and Dosi et al. (2018) design an insurance scheme on sovereign bonds in which risky countries pay annual insurance premiums valued at fair market price conditions.
[2] In the perspective of a debt reduction, this counter-cyclical arrangements works better than the current debt rule which tends to induce a pro-cyclical fiscal behavior.
[3] At the start each participating country instantaneously transfers on average debt worth 60 per cent of GDP. The example assumes that GDP growth is equal for all countries, interest rates and maturity structure are country-specific (those of the first quarter of 2018), primary balances evolve according to EU fiscal rules and the interest rate paid on ERF’s debt is equal to the weighted average of rates paid by countries on their own sovereign debt.
