This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
Eurobonds are today politically unfeasible…
Genuine Eurobonds with joint and several liability would bring significant benefits and stability to the euro area. Top of this list is credibility, further cementing that the euro is here to stay. Such an instrument would also price counter-cyclically as investors seek refuge herein during periods of market stress, just as we observe for US Treasuries today. This countercyclical property is important also for systemically important institutions, such as banks. The ECB would, furthermore, be able make ‘unlimited’ purchases of genuine Eurobonds for monetary policy purposes. A deep and liquid Eurobond yield curve would, moreover, offer a pricing reference for other financial assets and thus support the development of Europe’s Capital Markets Union. Genuine Eurobonds, however, do not appear to be politically feasible in the foreseeable future.
…but the status quo leaves the euro area vulnerable
At the same time, the status quo leaves the euro area highly vulnerable in the event of a major shock. The European Stability Mechanism (ESM) with potential support from Outright Monetary Transactions (OMT) are certainly welcome additions to the euro area’s crisis management toolbox. To avoid moral hazard, the ESM Treaty leaves the door open to private sector involvement (i.e. debt restructuring) for the sovereign debt of any member states that applies for an ESM programme. Our concern, however, is that in doing so the ESM Treaty creates a situation that could amplify stress in crisis.
If market participants see a high probability that a member state will apply for an ESM programme, then the perceived risk of debt restructuring will likely increase. Experience shows, that when markets place a high probability on debt restructuring, governments often lose market access. While the ECB can purchase on secondary markets, the European Court of Justice (2015) has made it clear that “the purchase of government bonds on secondary markets must not have an effect equivalent to that of a direct purchase of such bonds on the primary market”. We thus deem it unlikely that the OMT could be used to restore market access for governments. Indeed, as highlighted by Wolff (2018), the issue of debt restructuring is often treated all too lightly.
A proposal for a 20-year Purple bond transition
The reality outlined above has triggered a search for a euro area safe asset without joint and several liability. Alvaro and Zettelmeyer (2018) offer a very useful analysis of the four main approaches set out in the literature. In contract to these various proposal, ours does not aim to deliver a single safe euro area asset today. Instead, we propose a 20-year transition that levers on the Fiscal Compact’s requirement to reduce the excess general government debt above 60% of GDP by 1/20 every year. The amount of national sovereign debt consistent with the Fiscal Compact’s annual limit would be labelled ‘Purple’ and protected from debt restructuring under an eventual ESM programme. Any debt above the limit would have to be financed with ‘Red’ debt, that would not benefit from any guarantees. At the end of the 20-year transition period, when Purple bonds will stand at 60% of GDP, these could become genuine Eurobonds as set out in the initial Blue-Red bond proposal by Delpla and von Weizsäcker (2010).
During the Purple bond transition, each member state would continue to issue its own debt and be fully responsible here for. Moreover, the proposal does not require any changes to the existing government debt stock; the only changes required are to the ESM Treaty and the prospectus of the new Red bonds. The characteristics of the Purple bonds should allow this segment of the bond market to price counter-cyclically and remain open for new issuance even when a member state applies for an ESM programme. This, in turn, would lower the eventual financing burden placed on the ESM. Banks, for their part, would hold Purple bonds thus limiting contagion. At the same time, the limits on Purple debt ensure discipline as Red debt would be more expensive to finance. Moreover, the protection against debt structuring only applies under the conditionality of an ESM programme.
An illustration of the Purple bond proposal
To illustrate our proposal, assume that a member state has a 100% debt-to-GDP ratio on 1 January 2018. The Fiscal Compact aims to anchor fiscal discipline and thus secure public finance sustainability. The Compact’s debt brake rule requires that general government debt falls by 1/20 of the gap to the 60% debt-to-GDP target every year on average. Let’s assume, however, that the country fails to adhere to this and debt remains at 100% of GDP during the first 20 years and then declines by 1pp every year over the next 20 years. For simplicity, we assume all debt is bond financed.
Figure 1 Purple and Red debt: A hypothetical example
(bars show the general government debt stock at year-end)
Source: Own calculations
On 1 January 2018, the entire initial debt stock is labelled as Purple. At the end of 2018, the Fiscal Compact limit on the sovereign debt stock will stand at 98% of GDP = (100% - (100%-60%)/20). The country will need to refinance the maturing debt stock, here set at 19% of GDP, plus the budget deficit, here set at 1% of GDP, i.e. a total of 20% of GDP. Given the Fiscal Compact limit of 98% of GDP, the country can only finance an amount equal to 18% of GDP in new Purple bonds and must finance the remaining 2% of GDP in Red bonds. As seen from Figure 1, the stock of Purple debt will, by construction, stand at 60% of GDP in 2038 while Red debt, in our example, equate to 40% of GDP.
Purple bonds offer a path to genuine Eurobonds …
Purple bonds are still a far cry from genuine Eurobonds as there is no joint debt issuance and no joint and several liability. Our proposal does, however, offer a path hereto and importantly, one that avoids the ‘juniorisation’ of any of the existing sovereign debt stock that could otherwise see current bondholders seizing the courts, generating market disruption. Moreover, by gradually restricting the size of Purple debt in line with the Fiscal Compact, moral hazard should be avoided. Indeed, member states that fail to meet the Fiscal Compact goals would be forced to issue the more expensive Red bonds.
To implement our proposal, the ESM Treaty would need to be amended to introduce a no restructuring clause on Purple bonds. There would be no need, however, to alter the existing debt stock contracts which we see as an advantage. The new Red bonds would need to be issued with a clause making it clear that these fall outside the no restructuring clause that our proposal introduces to the ESM Treaty and contain Collective Action Clauses (CACs) to facilitate restructuring if needed. We advise strongly against any automatic debt restructuring rules as these might bring unnecessary disruption and render Red bonds more expensive than fundamentals may warrant.
…and greater stability today than status quo
The question is not just whether Purple bonds offer a politically viable transition to genuine Eurobonds, but also whether they would strengthen the stability of the euro area today compared to the status quo. For this discussion, we need to distinguish between two types of risk; the risk that a member state may be required as part of an eventual ESM programme to restructure its sovereign debt, and the risk that a member state may decide unilaterally to restructure and/or redenominate its debt in the context of a euro exit.
Purple and Red bond prices would converge under euro exit fears
Consider first the risk scenario where the financial market prices in a significant probablity of a euro exit. As detailed in the annex of Bini Smaghi and Marcussen (2018), the pricing of Purple and Red bonds of the member state in question would converge as the two bond types are essentially identical in this case and banks holding these bonds would suffer contagion. We would, however, expect to see less contagion to the sovereign debt of member states where euro exit fears are not present.
Low risk of contagion between Red and Purple debt under an ESM programme
Return now to the case where a member state applies for an ESM programme. Under our proposal, the member state’s Purple bonds would be fully protected from any debt restructuring, thus alleviating investor fears. Furthermore, there should thus be no problem for the ECB to conduct quantitative easing (QE) in these Purple bonds (if such a QE programme is warranted by the overall euro area conditions), to offer an LTRO that the national banks could then use to buy Purple bonds and/or for the ECB to provide support via the OMT programme, given ESM conditionality. As banks would hold only Purple bonds, there would, moreover, be no contagion to banks via their sovereign bond portfolios.
Red bonds would price very differently as these would be subject to restructuring risks and not enjoy the full spectrum of stabilising support from the ECB. As such, Red bond spreads would rapidly deteriorate and the government would lose access to Red bond financing. Given our assumption that the government in question would retain access to the Purple bond market, the ESM programme would only fund the share of debt issuance that would otherwise have been funded by Red bonds. The conditionality of the ESM programme should ensure progress on structural reforms and address unsustainable fiscal policies. This will take time to deliver, but once achieved should allow Red bond markets to re-open.
A point worth note is that at the onset of the Purple bond proposal, the overall cost of funding for government debt should decline, ultimately making it less likely that an ESM programme would be required in the future if governments use this window wisely.
The final point that we make is that as Purple bonds would benefit from the no restructuring guarantee this could allow the ECB to increase the issue limit from the current 33% on such instruments under the QE programme to the 50% awarded to EU supranational bonds. All the more so, if the one-limb CAC proposed by Bénassy-Quéréet al. (2018) is implemented. Given that Purple bonds would still be subject to redenomination risks, it would nonetheless be reasonable to maintain the current risk allocation, where 80% of the risk linked to the Public-Sector Purchase Programme still sits on the national central banks’ balance sheet. Red Bonds would not be eligible for QE. One criticism here is that more QE could result in a further build out of Target II imbalances. The ECB has already made it very clear, however, that any member state leaving the euro area would need to settle such obligations in full.
Authors’ note: The views expressed are attributable only to the authors and to not any institution with which they are affiliated.
Bénassy-Quéré,A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Veron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No 91.
Bini Smaghi, L and M Marcussen (2018), “Strengthening the euro area Architecture, a proposal for Purple bonds”, SUERF Policy Note Issue No 35.
European Court of Justice (2015), Press Release no 70/15, Luxembourg, 16 June 2015
Delpla, J and J von Weizsäcker (2010), “The Blue Bond Proposal”, Bruegel Policy Brief Issue 2010/03
Delpla, J and J von Weizsäcker (2011), “Eurobonds: The Blue Concept and its Implications”, Bruegel Policy Contribution 2011/02
Leandro, A and J Zettelmeyer (2018), “The Search for a Euro Area Safe Asset, Peterson Institute for International Economics”, Working Paper 18-3
Wolff, G (2018), “Europe needs a broader discussion of its future”, VoxEU.org, 4 May.