I’ve tried my best to ignore all European news and hysteria in the past couple of years. It’s been a wonderful time/sanity-saver for me! And really, what have I missed in the way of concrete political progress?! But enough is enough, how about a real bloody solution now..?
I was never impressed with the old chestnut that sovereign debt’s superior (to corporate) due to a government’s ability to impose & collect taxes. Sure, and it can spend just about any level of revenues too, among other failings..! Whatever the argument, you can’t escape the fact a nation is the embodiment of ‘Us vs. Them‘. When it comes to the crunch, government can always re-write, or tear up, any contract they wish – the ‘Us‘ inevitably comes first . [Hmm, I guess Ireland's the exception that proves the rule? God, the half-wits in power couldn't even fail properly..!]. So any type of in-country sovereign enhancement is pointless. And talk of, say, collateralization or sale of Greek islands is just plain ludicrous!
So, how does Europe shore up confidence in its debt? There’s plenty of talk about the ECB & LTRO, but these represent liquidity, not long term support or sustainability. We also have the ESFS, the European Fiscal Compact, plus a wild variety of other support/fiscal union ideas & proposals. [Of course, there's also default - markets are far quicker than politicians to grasp that debt problems are sometimes insoluble...]. I don’t see great clarity regarding the level of market or political support these command, or their long term feasibility and/or consequences. I’m just going to concentrate on a Eurobond proposal here.
So, who provides the guarantee? The ECB’s a candidate, but that just implies absolute political control. Ultimately, the buck stops with the Eurozone countries, whether it’s funding or simply a guarantee. [If it's politically desirable or expedient to include non-Eurozone EU countries in any proposal/solution, that doesn't present a huge issue]. But I think we all know the arguments & opposition to EU funding and guarantees: The legal status & regimes of existing debt, the dilution of sovereignty, the moral hazard, etc… I believe there’s a proposal that represents a happy medium:
It will allow countries to retain fiscal sovereignty (not saying that’s a good idea, long-term!), enjoy the benevolent umbrella of a Eurozone guaranteed debt scheme, while ensuring (dis-)incentives to promote good fiscal behaviour. It eliminates/sidesteps some key legal and/or logistical issues. It’s fast to implement, as it leverages off existing Eurozone financial infrastructure. Best of all, it offers better yields, time (the best remedy against default), and possibly an intriguing market opportunity to boot.
All countries sign a mutual pact to guarantee each other’s bonds up to, say, 75% of GDP. Each country is responsible for their share of the total guarantee, in accordance with their share of total GDP.
The percentage limit must be set at a level that’s effective, that rating agencies endorse, and that offers potential for significantly better (or, at worst, similar) yields. That’s obviously in AAA territory – somewhere, I’d venture, in the 60-80% of GDP range. Of course, politicians will push for the highest level possible… Since we know the agencies respond well to incentives, they can just threaten them with a few (well-deserved) lawsuits to get them on board..! No point in trying the market’s patience though, so let’s assume they settle on a 75% of GDP limit.
If a country refuses to sign up, for whatever reason, they can (possibly retaining the right to sign up at a later date). But what real incentive is there to stay out in the cold? If they opt-in, they’re simply exchanging their sovereign liability for a Eurozone-wide liability, up to the same 75% of their GDP. I guess a low-debt country (who?!) might balk, but probably sign up ultimately for what is the perfect back-up facility.
Remembering Greece’s shenanigans, each country agrees to permit the ECB to independently audit its GDP – annually is perfectly adequate. A higher GDP offers a country additional Eurozone debt capacity, while a GDP decline places some restriction on future issuance. Of course, any GDP-related adjustments won’t affect previously guaranteed debt in any way. The ECB will also track & publicly confirm each country’s guaranteed debt issuance, remaining debt capacity and any changes in total capacity. If the ECB lacks resources, they can just tap some of the tens of thousands of employees the Eurozone central banks insisted on retaining (despite a common currency?!).
The bigger issue is what happens if a country fails to pay/defaults on a debt maturity? The other Eurozone countries will obviously be on the hook. But how likely is that? At a 75% of GDP limit, a country can pretty clearly service debt principal & interest. Also, each country will initially have ample guaranteed debt capacity for refinancing, and over time an increasing portion of debt will become guaranteed. Once they reach a steady state, maturing guaranteed debt will be pretty much automatically replaced with new guaranteed debt issuance. Therefore, a Eurozone guarantee should hopefully prove academic, and the market will price accordingly. Worst case though, there’s still a small risk a country could stick it to its ‘partners’. But they have very different leverage to regular bondholders:
Under the mutual pact, a country’s non-payment/default entitles the other guarantor countries (as represented by the ECB) to implement a lock box arrangement on that country’s tax revenues to recover principal & interest. Failure to permit this triggers an escalating series of penalties & deadlines culminating in expulsion from the Eurozone (and potentially the EU).
Basically, if a country choose to act like a pariah state, its Eurozone partners are probably the first (modern) creditors who can actually enforce that status..! What country would want to tread that path? EU politicians could also slack off a little on their obsession with deficit limits & penalties (which offenders don’t take seriously anyway). Just leave it to each country to observe the difference in guaranteed & unguaranteed yields..! I can’t think of a better incentive for politicians to finally show a little deficit & debt restraint.
I obviously don’t envision actual Eurozone bonds or funding – I prefer the described guarantee scheme (grafted on each country’s debt issuance programme). It will permit pact countries to adjust, or terminate, any aspect of the guarantee scheme at any time (except on existing guaranteed debt). It also offers the possibility of easier migration to a more integrated debt/fiscal union in due course.
So how exactly will countries utilize this new debt capacity? However they like actually! Huh? Well, as I highlighted in my last post, the average European debt maturity is over 7 years. So, despite a hysterical financial media, high bond yields are actually fairly irrelevant. [And there's plenty more crying wolf - in too many quarters, no increase in spending apparently equates to austerity now?!]. So who bloody cares about yields until the day you have to refinance? And you’ve got years of guaranteed (low yield) debt refinancing capacity available anyway!
But what about a country’s (unguaranteed) debt in excess of 75% of GDP? Perhaps it will be marked down? Considering current sentiment (and certain yields & prices), that’s not a racing certainty… Here’s the beauty of it, countries can now play a marvelous game of chicken with the markets! Let’s say the market assumes guaranteed debt capacity will be exhausted before a country’s longer-dated debt matures, and they trash those prices. Just whack it with open market purchases or a tender, finance it with low yield guaranteed debt, and enjoy the reduction in nominal debt outstanding. Or there’s a high coupon or a low priced debt tranche that can be forcibly redeemed/called at a nice price – again, replace it with new low yield debt. Or the market re-evaluates, marks up long & short dated debt, and figures medium dated debt should be marked down instead – just switch your buying/refinancing tactics..!
As we’ve seen with bank debt, if you have nervous & uncertain bondholders, a flexible trigger & tactics, and access to new guaranteed funding, you can significantly impact the profile & nominal value of your outstanding debt. Perhaps other countries might feel sufficiently relaxed to just slowly absorb this new debt capacity as their current debt matures. They can still be ready to take advantage of market opportunities if they become attractive enough.
Of course, none of this will necessarily solve an excessive debt burden, but I never claimed I could cure politicians’ baser impulses either! Unless I get to tackle them one at a time with a car battery and some alligator clips… But what it does offer is: i) a (v meaningful) solution that’s pretty quick & easy to implement, ii) huge flexibility from a political and a financial management perspective, iii) interest savings, and even debt principal reductions, for most if not all countries, and iv) best of all, a multi-year window to avoid default, implement deficit reductions (faint hope) and/or ideally grow into an outstanding debt burden.