The COVID-19 crisis is set to propel the European Union for many years to come into a role its members had not anticipated: significant issuer of public debt.
If the EU’s budget and pandemic recovery package is approved, the 27-nation bloc will see its balance sheet transformed from occasional issuer to market stalwart. It will also take on a new role as market peer to some of the world’s most experienced issuers. How it manages that transition, and whether it supports or crowds the existing markets for euro-area government debt, will be almost as big a challenge as spending the money itself.
The Next Generation EU proposal (NGEU), now in the final stages of political debate, foresees EU borrowing of up to €750 billion on capital markets in the 2021 to 2024 period, with debt to be paid down between 2027 and 2058. This compares to EU issuance that has typically been €6 billion or less, previously peaking in 2011 at €29.5 billion. In the absence of the COVID-19 crisis, the EU would have expected to issue €800 million in 2020 and €10 billion in 2021, to roll over debt borrowed for prior rescue loans to Ireland and Portugal.
On the plus side, the euro area will benefit from having a new source of highly rated securities, often described as safe assets because of the role they play in market structure and risk management. Previous proposals for a safe asset have involved new forms of issuance, starting out at very low levels – for example, the sovereign bond-backed securities (SBBS) plan might have had initial issuance as low as €10 billion in its first year, according to preliminary studies. The NGEU strategy, in contrast, would benefit immediately from a more traditional issuance platform and a more meaningful scale. As Bruegel’s Alexander Lehmann has written, new EU bonds could boost integration between national financial systems, reduce the risk of runs on national bond markets, and help detangle the “doom loop” of interdependence among banks and local sovereigns. Also, demand for EU-issued debt is certainly there. Already markets are showing enthusiasm for one of the earlier programs put in place to fight the COVID-19 crisis: the temporary support to mitigate unemployment risks in an emergency programme, referred to by the acronym SURE. Under that programme, adopted in May, the EU will borrow on public markets to finance up to 100 billion in loans to member states. Its first issuance in October was oversubscribed by a factor of 13.
However, the new EU bonds also have the potential to cause challenges for existing borrowers in the euro-area market. Italy, for example, manages outstanding debt of more than €2 trillion with higher borrowing costs than Germany, France or supranational issuers like the European Stability Mechanism and the European Investment Bank.
Right now, while rates are low and in some cases negative, investors may seek out Italy’s slightly higher yields even if it means taking on more perceived risk. In late 2020, Italy’s 10-year yield is around 0.6%, a positive return compared to about -0.3% for France and -0.5% for Germany. EU projections suggest the bloc’s joint borrowing rates would be similar to France, albeit a bit higher in the very short term and a bit lower in the very long term.
But if rates rise from their current historic lows, or even if spreads widen significantly, investors may take a different view. That, in turn, could complicate matters for debt management offices in the euro area’s 19 capitals, especially in the long run and as EU borrowing spreads out to all points along the curve, not just longer-term bonds. It is conceivable that EU-issued debt could crowd out other euro-area sovereigns.
This could be because of purely technical factors, like a packed borrowing calendar, since the EU likely will need to borrow in a “back-to-back” way that is tied to its disbursement needs, not market funding trends. It could also run up against political factors, if investors began to differentiate seriously between centrally controlled finances and those governed at the national level. To be sure, coordination among debt management offices can mitigate much of this risk, but it will need to be considered as the EU becomes a permanent, large-scale market participant.
Avoiding market collisions may have motivated the initial plan, in May, for the recovery fund to be financed with debt at maturities between three and 30 years. Now that the EU is already in the market for SURE and positioning itself for further borrowing, the expected program is widening. The European Commission is expanding its in-house debt management capabilities and preparing for a borrowing schedule that may cover the whole curve, from bills to long bonds. This will require intense preparation, coordination with investors and outreach to other debt management agencies to keep the calendars as complementary as possible.
The EU’s broad-based response to the pandemic contrasts with the more limited resources assigned to the euro crisis, when markets were perpetually wondering whether the designated public backstops would be enough to stop waves of financial contagion. For political reasons, the euro area was always careful to calibrate its crisis-fighting capacity to the minimum necessary to stave off disaster. As a result, financial markets frequently tested its resolve, leading to a sort of arms race between available tools and market pressure. Furthermore, the EU sought to limit and constrain joint liability wherever possible. The ESM, an intergovernmental rescue fund owned and managed by the euro area, was eventually set up outside the main EU institutions.
During the euro area’s sovereign debt crisis, European officials designed a number of tools that were never used, including a proposal to leverage the EU budget to much higher levels. When the European Commission unveiled the European Financial Stabilisation Mechanism in 2010, as proposed it had two rungs: a first level, using €60 billion budget in existing budget headroom, and a second rung, in which the EU’s executive branch could draw on guarantees from member states as needed to create as much capacity as the situation demanded. At the time, lawyers representing the member states balked, saying it wouldn’t be possible to go beyond the official seven-year budget – they didn’t want to change the “own resources” ceiling or provide the proposed guarantees. The fund thus was limited to providing partial support to Ireland and Portugal, and guarantee-backed borrowing was turned over to intergovernmental institutions. At that time, member states sought to keep fiscal controls firmly in the hands of euro area member states. A decade later, these concepts may finally see the light of day. The EU is now using guarantees to back up its SURE program, and also planning to lift budget ceilings to backstop the NGEU initiatives.
As Gregory Claeys and Guntram B. Wolff noted, a safe asset has the potential to strengthen the euro substantially, especially if it is accompanied by increased political accountability over budget management. Investors might welcome this kind of increased centralization if it is linked to a rise in “own resources,” as the EU calls dedicated tax streams that fund the bloc’s budget. However, the EU Treaty still leaves most fiscal powers in the hands of sovereigns, and efforts to give Brussels more powers to sanction national finances have been met with resistance – not just from governments in the crosshairs but also from markets, who dislike additional sources of political uncertainty. Efforts in Brussels to set out economic standards have often been seen as favouring saver countries over those that manage larger outstanding debt levels; increasing issuance from the centre while also attempting to rein in national-level borrowing could be politically fraught, depending on how EU funds are distributed among the member states.
There is approximately €9 trillion in outstanding euro-area government debt, according to ECB data. The new package puts the EU balance sheet on course to reach €1 trillion in coming years, a substantial shift that will reshape the euro’s role on global markets.
From a market perspective, the EU is as strong as its strongest components, with an AA rating from Standard & Poor’s (S&P) and a triple-A top rating from all of the other credit ratings companies. Moody’s reaffirmed its top rating in September, saying the layers of guarantees and the EU’s “explicit recourse to extraordinary support”, which is to say paying back debt out of the general budget if needed, justifies this confidence, and indeed the EU’s “own resources” proposal makes clear that member states will be expected to back up each other’s guarantee calls if ever that were needed. S&P takes a different approach, saying it bases its long-term EU rating on “the capacity and willingness of the 11 wealthiest EU members (including the U.K., which is required to contribute to the EU budget until the end of the 2014-2020 MFF) that are net contributors to the EU budget.”
Political determination will be as important as fiscal firepower in ensuring the EU taps the market finance it needs. But if handled correctly, financial markets will be there with the money.
Christie, R. (2020) ‘Thinking big: debt management considerations for the EU’s pandemic borrowing plan’, Bruegel Blog, 09 December