Research Finance

Eurobonds as a Harbinger of a Fiscal Union

, by Fabio Todesco
A paper by Carlo Favero and Alessandro Missale defends the argument for a Eurobond but states that it is hard to think of solutions for the euro debt crisis without further steps towards political integration

The prevalence of market sentiments over fundamentals in times of crisis provides the strongest economic justification to the introduction of a Eurobond, specifically a bond "issued by a group of euro-area member states backed by several and joint guarantees: each participating issuer would guarantee the totality of the obligations", according to the definition provided by Carlo Favero (Deutsche Bank Chair in Asset Pricing and Quantitative Finance, Department of Finance and IGIER) and Alessandro Missale (Università di Milano) in Sovereign Spreads in the Euro Area. Which Prospects for a Eurobond?, a paper recently presented at the Economic Policy Fifty-fourth Panel Meeting, hosted by the National Bank of Poland. The Eurobond would allow heavily indebted and less disciplined countries to access the debt market at lower rates, but would benefit also the most fiscally disciplined countries, as it could avoid the propagation of crises at a lower cost than the intervention of the European Financial Stability Facility (EFSF).

The authors, though, admit that "it is hard to think of solutions of the euro debt crisis without further steps towards political integration" and suggest "some form of fiscal union to address macroeconomic imbalances with a common policy". "No doubt", they write, "the introduction of a Eurobond could signal a political will for greater fiscal unity, paving the way for deeper reforms of EU fiscal governance".

Favero and Missale dismiss the argument that the Eurobond would solve a liquidity problem which would affect the euro-denominated bonds market. Comparing yield spreads and Credit Default Swaps (CDS), they find that spreads are almost totally due to default risk, while liquidity risk is irrelevant, and thus focus on the components of the default risk.

Since proponents of the Eurobonds state that they could provide better market access to weaker member states by insulating them from financial contagion and could lower the risk of crisis propagation, while the opponents argue that Eurobonds would hamper market discipline, prolonging weaker states' reliance on debt, it's important to understand whether yield spreads reflect fiscal fundamentals (in this case markets should be let loose) or irrational fears (in which case markets wouldn't efficiently price risk and anything countering the contagion would be welcome).

The authors, through a Global VAR model, find that there is a relation between fiscal fundamentals (operationalized as the expected deficit- and debt- to GDP ratios) and yield spreads, but it's neither linear, nor constant over time. It isn't linear because a country's spread is more sensitive to the spread hikes in countries fiscally closer to it (i.e. with similar fiscal fundamentals) and less sensitive to the distant ones; it's not constant because there is an overreaction in times of crisis, signalling a market malfunction. In August 2011, in the middle of the Greek crisis, they reckon the contagion effect to be 200 basis points for Italy and even more for Spain. "Our evidence", they write, "suggests that relying only on the disciplinary effects of financial markets to halt a crisis may not be enough as yield spreads are significantly driven by market sentiment".

Political opposition to the Eurobonds is, nevertheless, powerful on the grounds of an unbalanced sharing of the benefits (for the undisciplined) and costs (for the disciplined) of the programme. The provision of joint guarantees is the only way for the Eurobond to obtain the same rates of the German Bund (in any other way the rate would be an average of the rates of the participating countries) and not to increase borrowing costs of Germany; even this way, though, the Eurobonds would be a cost for the most disciplined countries, which would see an increase in their liabilities. The empirical evidence provided in the paper speaks strongly in favour of"Conditional Eurobonds" with a collective underwriting guarantee issued by a new European Monetary and Fiscal Authority, where administratively set spreads will determine the annual side paymentsthat countries rated below Aaa will have to pay to countries rated Aaa in order to be able to access the programme.

The existence of administratively set spreads transparently related to economic fundamentals will keep intact the incentive to be fiscally virtuous for all countries and provide some compensation to the Dutch, the Finnish and the German taxpayers that insure the risk of less fiscally virtuous member states.