Financing post-pandemic recovery via EU borrowing has proved remarkably straightforward. So why keep it temporary?
The issuance of European Union bonds to finance NextGenerationEU (NGEU)—the common recovery programme agreed by member states during the summer of 2020—has begun. This represents a small revolution in the supranational bond market.
Before the Covid-19 crisis, the EU had been issuing bonds for decades but it was a relatively minor player in the bond market, only borrowing for small, back-to-back lending programmes. But with the debt issued for NGEU, the EU will become one of the major borrowers in Europe in the coming years—up to around €800 billion, depending on the amount of loans member states take out. It will already issue €80 billion this year and could issue up to €150 billion per year in the next five years, putting it on a par with major European sovereign issuers, such as Germany, France and Italy.
As documented in our recent paper, the first issuances since June have evinced strong interest from investors all over the world. This was to be expected, given the current high demand for safe, well-rated assets, as well as for ‘green’ bonds.
The European Commission has quickly assembled a qualified debt-management team and adopted a diversified borrowing strategy, similar to that of other major issuers, to raise money reliably and cost-effectively. This represents a significant change in the way the EU interacts with financial markets.
Before, given its relatively low borrowing needs, the EU could tap the markets opportunistically, as and when required or when financing conditions were advantageous. With this much larger issuance, it needed to put in place a strategy. To capture the lowest interest rate at a given time but also to ensure funding needs would be easily met in future, this would be defined by regular and predictable issuances, so that debt securities were attractive to a diverse investor base.
The EU has decided to establish its presence in the bond market over the whole yield curve, issuing debt securities with maturities ranging from three months to 30 years. It has established a a ‘primary dealer network’ of investors, which will participate in the syndicated transactions and auctions through which the bonds will be primarily issued. The primary dealers will also play an important role in secondary markets, to ensure that EU bonds are liquid, as investors want to be sure they can quickly and easily resell the bonds at a good price.
Not only will this allow the EU to finance its recovery programme very cheaply—even at negative rates at the moment. There could also be positive side-effects: if successful, this could lay the groundwork for a European safe asset and common-benchmark yield curve, help develop EU capital markets, improve the euro-area financial and macro-architecture and bolster the international role of the euro.
First, the eurozone has a longstanding shortage of safe assets: those rated ‘AAA’ or ‘AA’ represent only 37 percent of gross domestic product in the EU, compared with 89 per cent in the United States. NGEU could represent about 5 per cent of euro-area GDP. As EU debt is rated better than most member states’ debt, issuing at the supranational level mechanically increases the volume of euro-denominated safe assets.
Secondly, if the EU were to become a permanent large-scale issuer, the yield curve of EU bonds could become a European benchmark for interest rates. Such a cross-border reference point could reduce differences in financing conditions for companies across the EU and favour economic convergence.
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Mitigating the ‘doom loop’
Finally, large-scale EU-level debt could bolster the resilience of European financial markets, by reducing the potential magnitude of capital flights in times of market distress: the issuance of common debt sends a strong signal that European countries want to stick together in the long run. It could also help reduce the sovereign-bank ‘doom loop’, in which national banks are over-exposed to their sovereign’s debt, as EU bonds would provide banks with a truly common safe asset to fulfil their regulatory requirements.
Mitigation of the doom loop will however be limited. NGEU debt will be overshadowed by national debt held by banks, which represents 19 per cent of GDP in the eurozone. Resolving this longstanding issue would require permanent issuance at higher volumes.
Moreover, EU bonds remain less attractive to banks than sovereign bonds. In the current collateral framework for refinancing operations, the European Central Bank applies a bigger ‘haircut’ to institutional and agency debt than to central-government debt at the same credit rating and maturity. This should be addressed by the ECB, as such haircuts shape market perceptions of the safety of a debt security, determining whether financial institutions will be able to exchange them easily and almost at par against the ultimate safe asset—central-bank reserves.
The commission has done a good job and won praise from all stakeholders for its quick and efficient establishment of the borrowing programme. There are however potential risks, which the commission will need to monitor carefully to ensure that it maximises the benefits of the programme.
First, given the importance of the primary dealers in ensuring performance of EU bonds in secondary markets, the relationship with these investors needs to be managed carefully. The commission has to ensure, mindful of national sensitivities, that it is transparent and fair in its choice of mandated banks for issuances.
It should also monitor carefully how dealers play their role, to ensure EU bonds remain attractive, readjusting duties and incentives if need be. For instance, it could add market-making obligations in secondary markets if the liquidity of EU bonds is much lower than that for major issuers such as France and Germany (as measured, for instance, by bid-ask spreads) or it could increase its fees, lower than those of major EU issuers, should the incentives not be sufficient for dealers.
Secondly, there were initial fears that a large volume of EU debt issuances could have a ‘crowding out’ effect on demand for euro-area sovereign debts. So far, the risk appears low, because of market conditions, high investor demand and co-ordination among European issuers. Indeed, anecdotal evidence points to the opposite: the NGEU bonds seem to have caused crowding in, notably because of demand from non-EU investors encouraged by the positive signal of long-run European cohesion.
This should however be carefully monitored, as market conditions could change in the coming years—if, for example, the ECB were to reduce significantly its role in eurozone bond markets. Thus, it is crucial that sovereign and EU issuances remain well co-ordinated within the Economic and Financial Committee’s Sub-Committee on EU Sovereign Debt Markets. This includes member states’ debt-management offices, 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 an important limitation.
While market participants appear in their investment strategies to perceive the 2058 time-horizon as distant enough to consider EU bonds as if somehow permanent, there is evident appetite from investors for large EU debt issuances to become so. If the benefits envisaged manifest themselves and the risks feared do not, the EU would have good reason to prolong and reuse EU debt—or make it permanent.
This is part of a series on the National Recovery and Resilience Plans, supported by the Hans Böckler Stiftung