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Julian D. A. Wiseman
Abstract: A “Common European Bond” is: dysfunctional dog’s breakfast, the mess being temporarily hidden only by an absence of detail; and an Important Big Idea, rather like the euro itself.
Publication history: only at www.jdawiseman.com/papers/finmkts/20101207_common_euro_bond.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; 1. No Guarantee; 2. Mutual Guarantee (2a. Equal Funding Cost, 2b. Market Funding Cost, 2c. Agreed Variation in Funding Cost); Conclusion; Footnotes.
A Common European Bond has been suggested, for instance by Jean-Claude Juncker and Giulio Tremonti, the Prime Minister of Luxembourg and Minister of Economy and Finance of Italy, in E-bonds would end the crisis (Financial Times, 6th December 2010). This is an Important Big Idea.
A Common European Bond could mean one of several things.
Perhaps a Common European Bond means a single bond, which is combined but not mutually guaranteed. So Germany would pay 27%† of the coupons and principal, France 21%, Italy 17%; Spain 12%, etc., and each country would receive some (perhaps the same) proportion of the sale price. There is no mutual guarantee: if one country fails to pay, others continue to pay what they would, the investors losing that proportion of future payments.
Such an instrument would be of little consequence. It would be as if each country had issued a bond with the same maturity, the same coupon, the same coupon frequency and the same holiday calendar, and these bonds had been glued together. The large size may well promote liquidity (as recommended in Bonds: too many; too small). But this bond would do little to fix the problems of the eurozone: each country would continue to have its own liabilities, with little change to the non-existent default arrangements. Further, investment banks would be quite happy to unglue this bond, putting it in a trust, probably of a non-eurozone jurisdiction, that trust issuing various tranches of debt, each of which is a pass-through of a country’s share. This separation would be similar to the method used to strip US Treasuries before there was an official stripping facility.
Alternatively, a Common European Bond might be a bond with a several and joint guarantee. So each country would have promised to bondholders to pay the whole, with some private arrangement amongst the issuers as to who pays what proportion. Obviously, this bond would be perceived as being more creditworthy than a bond issued by Greece, or Ireland, or Spain or Portugal or Italy.
But would it be better than a bond issued by Germany alone? Not much: if Germany were to default, the euro would be worth approximately nothing. So if the non-German guarantee is used, it causes investors to be paid some monies with a real value of approximately zero. This is not worth much, so the yield should be close to that of a German bond, liquidity determining whether slightly above or below.
There are some sub-possibilities.
The seventeen eurozone countries are to sell a bond guaranteed by them all. It might be that all fund at the same price: Germany receives de% of the sale price, and is to make de% of the payments; Greece gr% of both sale price and payments; etc. So Greece would be borrowing at the same rate as Germany. Rephrased, Germany would give away, for nothing, its guarantee.
Such an arrangement has little chance of being acceptable to German voters, and about the same chance of being acceptable to the German constitutional court.
Alternatively, it could be agreed that the constituent countries have a funding cost proportional to their stand-alone funding cost. So if stand-alone Greece is funding at 12.5% and (stand-alone!) Germany at 2.50%, then the Greek funding rate is five times that of Germany, and the schedule of payments divided accordingly.
But this doesn’t protect countries at all from a rise in their cost of funding. If market yields rise, so does the cost of funding: what has been gained?
Alternatively, seventeen finance ministers could sit around a table in Brussels, and agree that X pays 2% more, but Y pays 1% less, this being based on some tame official definition of credit risk. (Well, as tame as is allowed by the German voters and constitutional court.) Yes, this means that the finance ministers would need to agree that Belgium is a worse credit than the Netherlands, and this un-European fact would need to be enshrined in an inter-governmental agreement.
Later, the credit-worthiness of governments will change, perhaps some better, perhaps some worse. If a country were to improve significantly beyond its tame official definition of risk, what would happen? Its self-interest would be to cease funding through the common bond, and to resume stand-alone issuance—so presumably there would be more negotiations. This might become market-with-a-lag, or another source of inter-European discord, or both.
Markets participants are unlikely to think that any such agreement is credible or sustainable: it will be as vulnerable to doubt as the abandoned ERM.
Whichever variation is chosen for new issuance‡, it is a dysfunctional dog’s breakfast, the mess being temporarily hidden only by an absence of detail.
But that’s not relevant: it has the appearance of doing something, and of doing something consistent with “ever closer union among the peoples of Europe”. That makes it an Important Big Idea, rather like the euro itself.
|— Julian D. A. Wiseman|
7th December 2010
† With GDP weights DE≈27%, FR≈21%, IT≈17%, ES≈12%, NL≈6.3%, BE≈3.8%, AT≈3.1%, GR≈2.6%, FI≈1.9%, PT≈1.8%, IE≈1.8%, SK+LU+SI+CY+EE+MT≈1.9%.
‡ The question of “what happens to existing bonds” is politely ignored.
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