by William R. Cline, Peterson Institute for International Economics
Op-ed in the Wall Street Journal
June 7, 2012
© Wall Street Journal
For a while earlier this year it looked as if the European Central Bank's trillion-euro Long Term Refinancing Operations (LTROs) might have begun to ease the European debt crisis. Not anymore.
In December, after the currency bloc's governments agreed to a tighter balanced-budget pact, the European Central Bank (ECB) issued €489 billion in three-year LTROs to member banks. At the end of February it lent a second installment of €530 billion. Partly because the banks used some of the funds to buy bonds from their governments, and partly because of structural reforms adopted by Mario Monti's technocratic government in Italy, interest rates for Italian and Spanish 10-year sovereign bonds receded to about 5 percent in mid-March from their December peaks of about 7 percent.
But recently the crisis has escalated again, to the point where it's contributing to the downturn of global equity markets, including in the United States. Growing evidence of Spain's banking problems and its need to revise its fiscal targets contributed to a moderate rebound in government borrowing premiums by mid-April. Then came the Greek elections in May, to be followed by a new round later this month and the specter of victory for parties that reject the Greek reforms.
All of this is raising the risk that Greece is set to exit the currency area. Uncertainty about the euro's future has now brought yields on 10-year government paper back up to 6 percent in Italy and about 6.5 percent in Spain.
It has become increasingly clear that the euro area needs to erect a financial firewall before Spanish and Italian yields spiral even further upward and create a self-fulfilling prophecy of insolvency. The firewall needs to be large: Medium- and long-term public debt maturing in 2012–15 amounts to about €900 billion for the two economies.
There are three well-known options for how the money might be delivered: through "eurobonds" of some type, in which sovereign risk would be mutualized with joint and several liability across euro-area governments; through a major expansion of the European Stability Mechanism (ESM), which lends directly to troubled governments at low rates but, at its planned level of €500 billion, is too small to deal with a potential crisis in Italy and Spain; or through the lender of last resort, the ECB.
But another large round of LTROs from the ECB might not persuade markets for long. And the central bank is unwilling to buy bonds directly from governments, in part because its mandates are generally interpreted as preventing it from doing so.
Germany has stoutly resisted scaling up the ESM in any major way, because it is the country most likely to be stuck with the bill in the event of losses. For the same reason, Germany has also resisted Rome and Paris's favored option, the eurobond, which Berlin says it could only accept with far greater fiscal centralization of the euro area—an institutional and political development that could take years.
However, no one seems to have considered a straightforward mechanism that would provide a cushion against potential losses for German and other taxpayers guaranteeing eurobonds: a bond-insurance fund, with premiums paid by the borrowing governments at rates reflecting their long-term creditworthiness.
Based on the past relationships of country ratings to sovereign-risk spreads, I have calculated that the interest rate on a eurobond might be expected to be about 45 basis points above the German 10-year bund, which currently yields about 1.3 percent. If the yield on the bund were to rise as high as 2.5 percent, placing the eurobond base rate at about 3 percent, there would be room for an additional sovereign-risk spread of up to, say, 250 basis points for a less creditworthy euro-area member.
That would still leave the eurobond as a means of borrowing at a sustainable rate, if not exactly at bargain levels. For example, the resulting rate of 5.5 percent on Italian bonds (with 3 percent paid to eurobond holders and 2.5 percent paid as a premium into the insurance fund) would permit Italy to reduce its debt-to-GDP ratio to 110 percent by 2020 from 122 percent today.
Over a decade at 250 basis points, the insurance premium would build up a sinking fund worth 25 percent of the face value of the debt and would be available to cover losses on sovereign risk before the guarantors of the eurobond would be called upon to make good. The arrangement would set insurance premiums at lower rates for more creditworthy countries, with the premium presumably at zero for Germany should it decide to borrow in eurobonds.
To arrive at country ratings for determining the insurance-premium bracket for each country, a weighted average vote of all members except the one being rated would be applied. Weights could be based on euro-countries' contribution shares to the ESM, or could reflect their potential liability shares.
For this purpose the executive board of the insurance fund could take into account existing sovereign ratings by major private international rating agencies. It could also invite technical analysis by IMF staff regarding how countries would be rated based on past international statistical patterns, while avoiding formal IMF board approval of the analysis. The arrangement could also provide that a country be disqualified from borrowing in eurobonds in a given year if it has strayed substantially from policies to meet its obligations in the EU fiscal pact agreed to in December.
Such a determination of eligibility again could be made by a weighted average vote of all members excluding the country in question. Alternatively, eligibility to borrow in eurobonds could be decided by a subgroup of countries whose shares in potential liability exceed their shares in outstanding eurobonds.
With the cushion based on bond-insurance premiums and controls on eligibility to borrow, it is conceivable that German officials would be prepared to go ahead with eurobonds. Apparently they are already giving some consideration to a suggestion by the German Council of Economic Experts for another type of common European bond.
In that approach, a "European Redemption Fund" with euro-area joint and several liability would take over government debt exceeding 60 percent of GDP. The fund would then repay it over 25 years from earmarked tax revenue set aside by the borrowers. In return for access to the fund, euro-area governments would implement German-style constitutional "debt brakes" to ensure adherence to the EU fiscal pact. A redemption fund would be an alternative firewall that could immediately assume about €1 trillion in Italian debt alone, for example.
Although that proposal warrants consideration, the insurance-premium approach to the eurobond put forward here seems considerably more feasible and would start at a much more moderate scale. Instead of relying on some form of tax sequestration, as in the redemption-fund approach, the bond-insurance approach would deal with the joint risk by building up a sinking fund based on reasonably calibrated country insurance premiums. How about it, Berlin?
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