Funding the post-pandemic recovery through EU borrowing has proven remarkably straightforward. So why keep it temporary?
The issuance of European Union bonds to finance NextGenerationEU (NGEU) – the joint stimulus package agreed by member states in the summer of 2020 – has started. This represents a small revolution in the supranational bond market.
Before the Covid-19 crisis, the EU had issued bonds for decades, but it was a relatively minor player in the bond market, borrowing only for small back-to-back loan programs. But with debt issued for NGEU, the EU will become one of the biggest borrowers in Europe in the coming years – up to around € 800 billion, depending on the amount of loans taken out by member states. It will already issue 80 billion euros this year and could issue up to 150 billion euros per year over the next five years, putting it on par with major European sovereign issuers, such as Germany, the France and Italy.
As documented in our recent paper, the first issues since June have attracted great interest from investors around the world. This was to be expected, given the current strong demand for safe and well-rated assets, as well as “green” bonds.
The European Commission quickly assembled a skilled debt management team and adopted a diversified borrowing strategy, similar to that of other large issuers, to raise funds reliably and profitably. This represents a significant change in the way the EU interacts with financial markets.
Previously, given its relatively low borrowing needs, the EU could exploit markets opportunistically, as needed or when financing conditions were favorable. With this much bigger show, he had to put in place a strategy. To capture the lowest interest rate at any one time, but also to ensure that financing needs would be easily met in the future, this would be defined by regular and predictable issuances, so that debt securities are attractive to a diverse investor base.
The EU has decided to establish its presence in the bond market across the entire yield curve, issuing debt securities with maturities ranging from three months to 30 years. It has established a “primary dealer network” of investors, who will participate in syndicated transactions and auctions through which the bonds will be primarily issued. Primary dealers will also play an important role in secondary markets, to ensure that EU bonds are liquid, as investors want to be sure that they can quickly and easily resell the bonds at a good price.
Positive side effects
This will not only allow the EU to finance its stimulus package very cheaply, even at negative rates for the time being. There could also be positive side effects: if successful, this could lay the groundwork for a safe European asset and a common benchmark yield curve, help develop EU capital markets, improve the financial and macroeconomic architecture of the euro zone and strengthen the international role of the euro.
First, the euro area has a long history shortage safe assets: those rated “AAA” or “AA” represent only 37% of gross domestic product in the EU, against 89% in the United States. NGEUs could represent around 5% of euro area GDP. As the debt of the EU is rated better than the debt of most member states, issuance at supranational level automatically increases the volume of safe assets denominated in euros.
Second, if the EU were to become a large-scale permanent issuer, the EU’s bond yield curve could become a European benchmark for interest rates. Such a cross-border benchmark could reduce differences in financing conditions for businesses across the EU and foster economic convergence.
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Mitigate the “fatal loop”
Finally, large-scale debt at EU level could strengthen the resilience of European financial markets, by reducing the potential scale of capital flight in times of market crisis: the issuance of common debt sends a strong signal indicating that European countries want to remain united in the long term. It could also help reduce the sovereign bank ‘doom slime’, in which domestic banks are overexposed to their sovereign debt, as EU bonds would provide banks with a truly common safe asset to meet their regulatory requirements.
Mitigation of the catastrophic loop will be limited, however. NGEU debt will be eclipsed by national debt held by banks, which accounts for 19% of GDP in the euro area. Solving this long-standing problem would require continuous emission at higher volumes.
In addition, European bonds remain less attractive for banks than sovereign bonds. Under the current framework of guarantees for refinancing operations, the European Central Bank applies a greater “discount” for the debt of institutions and agencies than for central government debt with the same credit rating and the same maturity. This should be dealt with by the ECB, as such haircuts form Market perceptions of the security of a debt security, determining whether financial institutions will be able to easily and nearly at par trade them for the safe ultimate asset, central bank reserves.
The commission did a good job and received praise from all stakeholders for its quick and efficient implementation of the borrowing program. There are, however, potential risks, which the commission will need to watch carefully to ensure that it maximizes the benefits of the program.
First, given the importance of primary dealers in ensuring the performance of EU bonds on secondary markets, the relationship with these investors must be managed with care. The commission must ensure, given national sensitivities, that it is transparent and fair in the choice of banks mandated for issues.
It should also carefully monitor how brokers play their role, to ensure that European bonds remain attractive, readjusting rights and incentives where necessary. For example, it could add market making bonds in secondary markets if the liquidity of EU bonds is much lower than that of major issuers such as France and Germany (measured, for example, by spreads between bid and ask) or it could increase its fees, lower than those of major EU issuers, if the incentives are not sufficient for brokers.
Second, there were initial fears that a large volume of EU debt issuance could have a “crowding out” effect on the demand for sovereign debt in the euro area. So far, the risk appears low, due to market conditions, strong investor demand and coordination between European issuers. Indeed, anecdotal evidence points to the contrary: NGEU bonds appear to have caused an influx, not least due to demand from non-EU investors encouraged by the positive signal of long-term European cohesion.
This should be watched closely, however, as market conditions could change in the years to come, if, for example, the ECB drastically reduces its role in eurozone bond markets. Thus, it is crucial that sovereign and European issues remain well coordinated within the economic and financial committee. Subcommittee in the EU sovereign debt markets. This includes the debt management offices of the member states, the European Stability Mechanism, the European Investment Bank, the Commission and the ECB.
Overall, EU bonds could offer significant benefits to member states. Yet the temporary nature of NGEU represents a significant limitation.
While market participants appear in their investment strategies to perceive the horizon 2058 as far enough away to view EU bonds as permanent, investors are clearly inclined to see large EU debt issues on the horizon. become. If the envisioned benefits materialize and the feared risks do not materialize, the EU would have good reasons to extend and reuse the EU’s debt – or to make it permanent.
This is part of a series on National Recovery and Resilience Plans, supported by the Hans Böckler Stiftung