‘Pain for progress’: Pan-euro bonds inevitable

Unofficial proposals to create government debt backed by the entire 17-member eurozone would produce a massive bond market, similar in size, liquidity and quality to the $7.3 trillion U.S. Treasury market.

The proposed pan-European bonds would be more diversified than German bunds, the current European standard. The move also would calm market volatility caused by bailouts of countries such as Greece and Ireland, and by concerns over debt loads of Spain and Italy. The size of the German bund market is about 2 trillion euros ($2.86 trillion).

The creation of eurozone bonds is fraught with roadblocks, however, as economically stronger nations would need to back the debts of weaker nations, which in turn would have to relinquish some sovereignty over their spending and debt levels.

NO CHOICE

Although moving toward greater fiscal integration in the eurozone will be a tough slog politically, it’s either that or a disintegration of the union, bond managers said.

“It’s becoming increasingly difficult [in the next 10 years] for the eurozone to remain in its current form without some kind of fiscal integration,” said Myles Bradshaw, senior vice president and portfolio manager in London for Pacific Investment Management Co. LLC.

“The market is going to force the eurozone to come up with a decision — is it going to be a full fiscal union or are we going to move down the disintegration route?” added Andrew Belshaw, head of investments in London for Western Asset Management Co.

Either way, the eurozone will be remade, experts said, and any partial breakup of the union would be a lot uglier than proposals to fix it. Central to those proposals are fiscal integration, which likely will include a move to eurozone bonds, and a relinquishing of some sovereign budgetary and debt-level oversight to centralized European authorities.

Also key will be guarding against moral hazard, or ensuring that highly indebted countries are encouraged to act with more fiscal responsibility.

“In the end, some degree of give-up of sovereignty through fiscal integration and more-effective rules that prevent moral hazard … is a necessary precondition to a real, lasting solution to the problem,” said Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management.

Eurozone bonds would help solve the European debt crisis in a number of ways. Primarily, they would lower the debt costs of peripheral European countries, enabling them to meet obligations more easily.

“It’s a way to help countries and restore confidence in the market,” said Martyn Simpson, a senior associate in Mercer LLC’s manager research boutique.

The move also would erase speculators’ ability to differentiate among — and invest against — individual countries’ debt.

“What we need is for investors to have a flight to safety like there is in the United States,” that is, from equities to government bonds, not from state to state, said Erik Jones, professor of European studies at Johns Hopkins University’s Nitze School of Advanced International Studies.

“We have to stop the flight to safety from moving across country boundaries,” said Michael Krautzberger, a managing director and head of euro fixed income at BlackRock Inc., adding that he doubts the popular notion that eurozone bonds would increase Germany’s borrowing costs. Instead, a more liquid market would reduce the liquidity premium and increase the euro’s attractiveness as a reserve currency.

“If there’s a [difference in costs] — and that’s a big “if’ — it would be a marginal one,” said Mr. Krautzberger, who’s also BlackRock’s Germany chief investment officer.

Most experts agree that eurozone bonds will be created — the question is when. “This is not something that can be done overnight,” Mr. Belshaw said. “It’s a medium-term goal.” For most experts, that means a time frame of one to two years.

But Jacob Funk Kirkegaard, research fellow at the Peter G. Peterson Institute for International Economics, said that because eurozone bonds would entail a remaking of the eurozone — much like the process to create the euro in the 1990s — a minimum of five to seven years is more realistic.

He sees the situation as a Catch-22, in that eurozone bonds would help ease the burden of indebted nations, but that “you can only have joint guarantees between European countries that are all in a fiscally similar position. It’s not clear that Italy or Spain” would meet those criteria.

Mr. Belshaw said eurozone bonds would just “buy time.” The roots of the sovereign-debt crisis are “more than a debt-financing problem”; it’s a matter of lack of competitiveness among highly indebted states, he said. “The underlying cause is what has to be addressed first of all.”

Given that determining the full scale of the problems and setting up the legal and practical framework needed to issue eurozone bonds are likely to take years, European leaders need to make a clear commitment to save the eurozone in the near term, experts said.

UNDER CONSIDERATION

The European Commission is studying the subject, but there has not yet been an official proposal made for creating eurozone bonds. However, bonds issued by the European Financial Stability Facility — the bailout fund that has issued pan-European bonds to help pay for bailouts of peripheral countries — set a precedent, Mr. Kirkegaard said.

In fact, managers believe the profile of the new bonds likely would be very similar to EFSF bonds in that they would be AAA-rated and trade at spreads of about 50 basis points over current bund yields.

Proposals for eurozone bonds have been years in the making but have taken on urgency since Europe’s piecemeal solutions to bailing out individual countries hit a wall by the predicaments of Spain and Italy, each too big to save by the EFSF. Experts said the details of how eurozone bonds are structured will be key, and so far, a proposal from the Bruegel think tank has gotten the most attention.

That proposal calls for limiting a country’s issuance of eurozone bonds to 60% of its gross domestic product in securities called “blue bonds,” with any debt issued over that ceiling to be backed only by the country issuing the debt, and known as “red debt.” That provides both lower yields through the blue bonds — to reduce the borrowing costs across Europe — and higher yields on red debt — to send a clear signal that a country is on an “unsustainable fiscal path,” according to a May 2010 Bruegel policy brief on the proposal.

“If financial markets are failing Greece now, they failed Greece even more before the crisis by continuing to provide cheap funding while [its] fiscal policy was reckless,” according to the brief.

An agreement on details is a long way down the road — a road that will continue to be bumpy until leaders commit to a policy of greater fiscal integration, experts said.

“None of these choices is highly popular, so politicians will ignore the need to decide” until they have to, Mr. Krautzberger said. “In Europe, for progress, you always need pain.”

Drew Carter is a reporter at sister publication Pensions & Investments.