Is It Eurobonds Or Bust For The Eurozone?

By FOREX.com | August 24, 2011 AAA
Is It Eurobonds Or Bust For The Eurozone?

By Kathleen Brooks: Research Director UK

After raging for 18 months, investors want the EU authorities to come up with a long term solution to the debt crisis. However at the recent meeting between German and French leaders, the idea of Eurobonds - considered to be the ultimate solution to the crisis - was cast aside as unrealistic.

But what are Eurobonds and could they actually solve Europe's problems? Right now each individual member country issues its own debt. Some may say that was the source of the current sovereign debt crisis; some countries borrowed far too much. For example, Greece's EUR350 billion debt load is roughly twice what some analysts consider Greece can actually pay back.

A Eurobond would see member states issue debt jointly. This would most likely have to be managed from a central European debt agency and there would be limits set to the amount each member could borrow. If a country wanted to borrow more than its Eurobond allowance, they could do so but interest rates would be higher.

What is the Benefit of this Plan?
Firstly, it might help to instil fiscal discipline. One of the reasons for the debt crisis in the first place, was that after the euro was introduced, interest rates for member nations converged. As we have now found out this was a catastrophic mistake. If the Eurobond means that all nations could borrow at the same rate, wouldn't that make the debt problem worse?

Well, no, since there would be strict limits to the amount each nation could borrow, which was missing prior to the debt crisis. If countries breach these limits, then their borrowing costs would rise, which should act as a deterrent to breaking fiscal rules.

Secondly, it would take the pressure off some of the larger creditor nations who are liable for the EFSF rescue fund. This is particularly a problem for France. It already has weak debt dynamics with a debt-to-GDP ratio of 80%. Some analysts suggest that the fund needs to rise to EUR1 trillion or more - it is currently EUR 440 billion - if it is to act as a financial back stop for both Italy and Spain.

That would mean France would be liable for one of the largest shares of the fund, aggravating its debt position even more. So the EFSF rescue fund itself, may end up causing contagion and threatening Europe's largest economies. Closer fiscal union would eradicate the need for the EFSF since it would give bailed-out nations a route back to financial markets to raise money and pay off their previous debts.

Is Fiscal Union the Answer?
The markets woke up to the sovereign debt crisis in Europe about 18 months ago and they want a solution now. It took the best part of 50 years for Europe to agree on monetary union; fiscal union may not take that long, but we are probably talking a number of years as opposed to months, before it could be instigated. Also, France and Germany, in particular, have expressed reservations about a Eurobond, which rules it out in the near term.

Other nations, including Finland, Austria and the Netherlands, have expressed their dislike of bailing out member states, let alone closer fiscal ties, so the introduction of a Eurobond could well cause the breakup of the Eurozone - the very thing it is trying to protect.

How do Europe's Leaders Avoid a Meltdown?
There aren't many options left without Germany stepping up to the plate and boosting its contribution to the EFSF. Aside from that, the European Central Bank (ECB) could continue to purchase debt in the secondary bond markets and help keep a lid on yields, especially for Spain and Italy.

The central bank also needs to provide liquidity for Europe's banking sector, so that funds don't dry up as a result of financial institutions' exposure to sovereign debt.

Fiscal union is not an easy solution to this crisis and if markets think this is the only answer, then they could be left sorely disappointed. Europe is not going to fundamentally alter its constitution that quickly. Europe's sovereign problems will rage on for some time yet.

There are some remedial solutions that could be provided by the ECB, but while growth remains lackluster, things are likely to get worse before they get better. Europe's central bank has its work cut out for it in the coming months.

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