Can eurobonds help resolve the debt crisis?

CALLS are growing for eurozone states to consider issuing bonds jointly underwritten by all 17 countries in the bloc — so-called eurozone bonds.

Some analysts believe such a step could help resolve the debt crisis.

Germany is the eurozone’s most powerful economy and enjoys the lowest sovereign borrowing costs.

It stands to lose most if such bonds were introduced as it would effectively end up having to underwrite weaker, more risky member states. Therefore, German Chancellor Angela Merkel is adamantly opposed.

Below, we look at some proposals and at how realistic euro bonds are.

What proposals are out there?

Bruegel, a Brussels-based think-tank whose research frequently informs EU policy, last year put forward a proposal for separate ‘red’ and ‘blue’ bonds.

Under the plan, eurozone bonds — blue bonds — would be issued jointly and collectively up to the value of 60% of each eurozone member state’s gross domestic product (GDP).

Borrowing beyond that level would require an individual state to issue red bonds without the collective guarantee of the eurozone, with the market likely to charge a higher yield to reflect the additional risk.

The disparity in financing costs between blue and red bonds — potentially a jump of more than 50% by some estimates — would be a big incentive for eurozone countries to bring their debts rapidly down to below 60% of GDP, the limit originally targeted by the EU.

Berlin-based economist Hans-Joachim Dubel has proposed creating European sovereign ‘purple’ bonds that are part-insured by the EU’s rescue fund — the European Financial Stability Facility (EFSF).

Each bond would be split into senior and junior tranches, with the senior section, around 60% of the total, insured by the EFSF and its successor, the European Stability Mechanism (ESM).

The ESM would become a monoline bond insurer that in the event of a default would pay investors quickly and in full on 60% of their assets, while the junior debt could be restructured. Such junior debt could trade separately after a default.

The dual structure would mean sovereigns are charged a higher interest rate than for blue bonds, reflecting the implicit 40% first loss carried by the uninsured junior tranche.

So the mechanism would still provide an incentive to avoid excessive debt issuance when times are good.

At the same time, the 60% risk protection would help moderate spread increases during crises, meaning countries could continue to raise funds at a lower cost than via red bonds.

Some economists propose creating a central European debt agency that would issue bonds on behalf of any member country that needed financing.

Unlike the EFSF, which is only designed to help rescue euro zone members that are in trouble, the debt agency would regularly issue bonds for individual countries. Strong guarantees — for as much as 300% of the value of the borrowed amount — would help ensure the bonds were highly rated.

Are these proposals practical?

Bruegel concedes its proposal was drawn up when debts were significantly lower across the eurozone.

Nobody has really discussed what institutions would need to be set up, what they would be modelled on and what would become of the eurozone finance ministries.

Why are politicians in Germany so wary?

German politicians say a common euro bond initiative creates a “free-rider” situation where bigger economies are saddled with the liabilities of weaker members.

Germany says the idea cannot even be entertained until there is much tighter fiscal coordination and a more level tax field across the eurozone.

What about sovereignty issues?

The toughest issue is the loss of sovereignty that national parliaments would confront if euro bonds were introduced.

To make the bonds work and avoid excessive borrowing, Germany would almost certainly insist on creating a central authority responsible for reviewing national budgets and financing needs, with the right to a veto.

It would effectively mean the setting up of a pan-eurozone finance ministry or fiscal authority, undermining one of the most fundamental sovereign powers of a state — taxation.