Back in Fashion

Eurobonds are back in action. This time we have been labelling these fixed-income instruments as (obviously?) “the Coronabonds”. EU leaders have argued for the issuance of these kind of instruments already in 1999: a shared debt instrument to finance borrowing, where the money is allocated to the countries that need it the most. The idea of an Eurobond has failed to receive sufficient support back then. National governments issue their own sovereign bonds, but they do so at varying costs. Thus, government bond yields within the Euro Area are heterogeneous. For example, Germany can practically be paid to borrow, whereas some Southern European countries (with less impressive credit ratings) issue government bonds with higher yields. While the Euro Area has battled for many years on how to narrow inequality within the block, the Corona pandemic, once again exposed those inequalities. Some of the most indebted Euro Area members have been hit the hardest during this pandemic. The virus led to a renewed push for this never-before-tried debt instrument.  Although we are in a different situation now, the idea remains the same: let European countries access funds to boost spending, and lower taxes without pumping up government debts. The main advantage of a Coronabond is that it would make it cheaper, in the aggregate, for countries to borrow. The proposal is as follows: The Coronabonds will be a one-shot issuance, whereby the member states jointly issue approximately 1000 billion euros, which is equivalent to 7.5-8% of the GDP of the Euro Area. The member states are jointly liable for the repayment of the bonds; the amount of interest payments could be based on the ECB capital key. 

The idea sounds appealing on paper, but in reality this is more complicated. Issuing Eurobonds entails a political choice in which members of the Euro Area transfer their sovereignty to Europe. Although this might be desirable in the view of many, it would not be easy and quick to achieve this from a political perspective. At this stage, only nine members of the euro area favour this idea. Especially Southern European countries and France agree on a form of debt mutualization/pooling. However, this was met by resistance and rejection by (as you might’ve guessed already) Germany, the Netherlands, and Austria, thereby complicating efforts to reach an agreement aimed to tackle economic and financial problems induced by the corona pandemic. 

Coronabonds are simply impractical for multiple reasons. First, it is not clear who will issue these bonds and how the payment allocation will look like. In the ideal situation, the Euro Area sets up a treasury with a federal budget, however this requires government to give up tax revenues during times of financial stress. Second, one may wonder to what extent Coronabonds are compatible with Art. 125 (1) TFEU, the Treaty on the Functioning of the European Union, and whether the EU law provides a sufficient legal basis for the issuance. Lastly, a federal treasury would demand checks on how member states spend their money, to avoid governments getting a free ride. Also, what would be the repayment terms, who will manage, pool and process the loans from it? Can banks use the bonds for refinancing with the ECB? Can the ECB buy such bonds as parts of its purchasing programmes? Agreement or not, the legal, practical and political hurdles to issue these mutualized debt are enormous. Even if all members would agree, the issuance of these bonds would come in place too late. Irrespectively, the problem of future debt is real, which raises questions whether alternative solutions exist. 

At first glance, I would say that direct lending by the ESM (the European Stability Mechanism) is the most straightforward option. The ESM, in the past, has been used as a lender of last resort for some member states of the Euro Area. So far, the ESM only has used its reactive instruments, for examples loans (to Ireland, Portugal, Spain, and Greece), which were linked to fiscal adjustment programmers. At this stage the ESM is able to issue an additional 400 billion euros if necessary. However, the problem with the ESM is that loans can only be granted conditional on imposing certain adjustment programs, which contains a series of (austerity) conditions. Using the ESM is likely to signal fragility to markets (a country might be perceived as fiscally weak) and a loss of sovereignty (due to the imposed conditions). However, the current economic situation is caused by an exogenous shock (a virus), rather than loose fiscal policy. 

The ESM also provides for preventive measures (article 12 (1) and article 14 of the ESM Treaty) as the ESM aims to safeguard the financial stability of the Euro Are: The Precautionary Conditional Credit Line (PCCL) and Enhanced Conditions Credit (ECCL). The PCCL can be used for countries with a healthy financing position. If a country is not eligible for the PCCL (for example Italy), the ECCL can be used. The ECCL, however, comes with much stricter conditions than the PCCL, but less severe than with normal ESM loans. ECCL seems to be a rather suitable instrument, rather than a Coronabond, for the weaker member states of the Euro Area. Both, PCCL as ECCL run for one year, and can be extended twice for 6 months. 

Another solution would be to create a special ESM credit line with conditionality limited to ex-post monitoring the use of these credit lines to tackle the crisis (as proposed by Olivier Blanchard), and a much longer maturity than PCCL and ECCL. Allocation across member states are proportional to the impact of the Corona pandemic, and damage incurred by the economy.  Conditionality in this case should not involve new discretionary spending nor tax reduction measures that are not related to the Corona crisis. This option would represent a concrete improvement in comparison to the current situation. Coronabonds seem to raise more complex questions than using ESM. Given the time span, it is very hard to solve and answer these questions and issue such instruments within time. Preferably, a new credit line within the ESM structure would be implemented rather than the issuance of Coronabonds. 

Amar Soebhag