A European Debt Agency as a structural response to the crisis

Massimo Amato is Professor of Economics, Bocconi University, Milan. The full paper, whose key points this post seeks to summarise, can be downloaded here in pdf format.

Foreword

This post sums up the results of a collective research [1] and aims at providing the fundamental elements of a feasible European Debt Agency (DA). The DA is meant to be charged with financing sovereign debts with advantages both for the Eurozone Member States (MS) and for the system as a whole. The proposal has a structural character, but the DA is designed in such a way as to enable its application even at the present emergency juncture. 

The problem

Before 2010, interest rates of peripheral MS were lower than their fundamental risk. Since the 2010 crisis, however MS public debts have started to diverge in markets’ evaluations well beyond what the issuers’ fundamental risk justifies. In other terms, there is now a liquidity risk that makes some debts vulnerable and results in a flight to quality towards others. The effects are overall negative

1.  for countries that experience unjustified spreads with respect to their fundamentals, as spreads translate in disproportionate and self-feeding debt-service costs;

2. for countries that only apparently benefit from the flight to quality, as the latter engenders equally unjustified negative yields that undermine both their banks’ profitability and their insurance and pension systems’ stability;

3. for systemic financial actors (banks and insurance companies) that are actually facing a safe asset shortage, which makes it difficult for them to manage their business cycles (for banks, the liquidity cycle; for insurance companies and pension funds, the management of the guarantees on return on investment);

4. for the Eurozone as a whole, as divergences in bond yields do constitute a constant threat to the stability of the Union as such.

If all that applied already before the emergency, the health crisis and its economic consequences, in terms of an irrepressible need to expand public deficits, put pressure on the actual setup and show its fragility.

The suspension of the Stability and Growth Pact (SGP) allows MSs to go into debt beyond constraints imposed so far but does not solve the problem of financing those debts. In fact, it exacerbates it. Even the suspension of the capital key for sovereign bond purchases by the ECB does not constitute a structural solution, as it implies a form of mutualisation that cannot be left in the hands of a purely technical body. Thus, we need an instrument that allows all MSs to finance increasing debts in the market without accentuating the centrifugal forces listed above. 

The Debt Agency

The proposal is of a European Debt Agency. Based on an adequate solvency capital endowment, the DA can

1. collect liquid funds in markets by issuing plain vanilla bonds with finite maturity;

2. use these funds to finance MSs with infinite maturity loans.

The DA does not purchase outstanding debt but only MSs’ new or expiring debt, buying it on the primary market. This is done according to predetermined price formulas based on the MSs’ fundamental risk.

Being perpetually held by the DA, the share of debt financed through the DA is structurally hedged from liquidity risk.

For this reason, as well as for the presence of an adequate solvency capital endowment, no seniority clause is needed to support the creditworthiness of the DA. This avoids a dualistic situation between debt in the DA and floating debt in the markets.

The DA receives from each MS an annual instalment calculated on the basis of its fundamental risk only, anchored to its official rating: the DA filters the market liquidity spread risk. Then, the overall flow of instalments, net of legal provisions, allows the DA to remunerate its bondholders at a rate which is in line with its high credit standing: therefore, it will be at most equal or lower than the fundamental cost for each MS (corresponding to the returns of the DA’s underlying portfolio). Thus, the DA reaches its financial equilibrium at more advantageous conditions than any portfolio manager in the market. 

Mutualisation and moral hazard

States could borrow through an agency that acts as a private entity in interfacing with markets but has the public mission of minimizing borrowing costs for the States themselves. The DA framework is entirely neutral with respect to any political configuration concerning collaborative relationships between the MSs the European legislators could adopt.

In the fundamental hypothesis of the abovementioned study, instalments paid by individual countries to the DA respond to criteria of strict proportionality to their fundamental risks. Clearly, the advantage of such a solution is to prevent any form of moral hazard.

Nevertheless, the instalments may be calculated in order to respond to criteria of mutuality, with a demonstrable gain in efficiency and welfare for the Eurozone as a whole. Each MS would pay on the basis of the average unit cost, and proportionally to the debt conferred to the DA. It can be proved that this scheme minimizes the overall financing cost of the whole debt load at the Eurozone level. 

Advantages

By acting as a protective gap between the issuing MSs and the markets, the DA allows

1. MSs to pay an instalment which is linked to their fundamental risk and only to that;

2. markets to have an asset filtered from the liquidity risk of underlying MS debts, hence more secure than any possible portfolio;

3. systemic financial operators to escape the home bias, with great benefit to the banking system and without the necessity to revise the prudential regulation on the treatment of government bonds for the purpose of solvency;

4. the system to consider the Eurozone as a homogeneous space, thanks to the progressive dissolution of the doom loop, namely the vicious circle that links at present the solvency of MSs to that of the respective banking systems and vice versa.

The potential role of the ESM or of the European Recovery Fund

With a capital endowment of 700 billion euros (80 billion in the form of paid-in capital and approximately 620 billion in the form of callable shares), the ESM can provide direct loans up to 500 billion. However, from a fund that provides loans in the short to medium term under potentially vexatious conditionality, the ESM can turn into a DA already adequately capitalized with respect to solvency requirements. Thus, it would be able to collect large amounts of funding in the markets at advantageous conditions, and to stabilize government bond yields (while structurally reducing spreads) as well as markets and financial operators’ balance sheets, in so far as it could provide them with an authentic European safe asset.

By financing itself through obligations, and financing not the outstanding debt but expiring or new debt only (for instance the emergency debt for the crisis), the new ESM as a DA could

1. gradually transform all MSs’ debts into perpetuities;

2. filter the volatility linked to the liquidity risk generated in the markets;

3. allow an organized and coordinated expansion of public budgets, both to consolidate the response to the crisis and to enable infrastructural investments in individual countries as well as in the Union as a whole.

An even more direct hypothesis, which is consistent with the recommendations proposed by the Eurogroup on April 9th, is to link the process of building the DA to the constitution of the Recovery Fund.

Thus, unlike the ESM, the DA would not be an intergovernmental instrument, but a communitarian one, in compliance with the provisions of article 122, paragraph 2, of the Treaty of Lisbon. It is meant to be initially bound to an enhanced cooperation vehicle (article 20 TEU and article 326 TFEU).  

The role of the ECB

In the context of the renewed architecture here proposed, the ECB in its turn

1. could indirectly support the activity of the DA by using its own instruments to ensure alignment of the new European “safe asset” yields with the “risk free” interest rate. These interventions, referring to a common bond that does not imply any kind of mutualisation, would be perfectly in line with the principle of the capital key.

2. could reduce the volatility of spreads on debt external to the DA, by continuing the public sector purchase programme (PSPP), being free, in this case, from the capital key constraint. In any case, this support action would be residual, as the share of floating debt would progressively diminish.

Footnotes

[1] M. Amato, E. Belloni, P. Falbo e L. Gobbi, “Transforming sovereign debts into perpetuities through a European Debt Agency”, WP, University of Trento