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Blog: Why EU’s 'Euro Bond' Solution Won’t Work

Moorad Choudhry
Friday, 19 Aug 2011 | 5:43 AM ET

The “Euro bond” solution to the euro zone’s sovereign debt problems appears to be an idea whose time has come.

European Central Bank
European Central Bank

The basic principle is simple: debt is issued in the name of the euro zone as a whole, thus enabling those countries experiencing funding problems to continue borrowing from the markets and at much lower rates. The bonds would be rated triple-A, reflecting the credit strength of the northern euro zone.

There have been a number of proposals on how a euro bond scheme would work. One version put forward by the Bruegel Institute has been termed the “red-blue” bond. Euro zone members would issue common bonds up to a maximum of 60 percent of their own GDP with the bonds all rated triple-A and paying the same yield. This would constitute the “blue” tranche.

The “red” tranche would be any debt issuance beyond this amount (bear in mind that all the southern euro zone countries issued debt above this level in 2010), issued by each country at its own credit-risky yield. In theory, the higher rate payable on the red tranche is an incentive for countries to reduce the deficit funding requirement to a minimum over the blue tranche level.

In the red tranche, the interest spread between different euro members would remain the same as before, thereby addressing the worry about northern euro countries subsidizing southern ones. The latter would have, in theory, guaranteed market access.

As someone who has always been interested in structured finance solutions, for me this is a neat idea. It’s just a pity that it won’t work, for technical as well as geo-political reasons. This is because the idea boils down to the same old thing, southern euro zone government borrowing that is being underwritten by the northern euro zone taxpayer. Which makes the joint bond idea no different to every other solution presented by the EU since the crisis began, all of which have failed to restore market confidence.

Investors started demanding a higher premium for holding southern euro zone debt when they began to worry about its credit quality. This will still affect the “red” tranche. Meanwhile, the “blue” tranche would amount to a 5 trillion euro market – how tenable is it that it would still be triple-A rated for long? It is almost inconceivable that the bonds would not be downgraded, especially if the lower government spending levels required to make the project work don’t materialize.

In essence, a substantial chunk of low-grade debt would now be underwritten by Germany, France, the Netherlands and the remaining triple-A-rated economies. And this is before there is any economic restructuring. If debt levels are not reduced, the market will stop buying red tranche bonds in any case, and we are right back to where we started.

No matter how it is structured, the euro bond idea will have the same impact as every other “solution” presented up to now, whether it is governments stating “there will be no default!”, the establishment of the EFSF facility, or the ECB buying up Spanish and Italian bonds – it will buy some time, but no more than a year at most and possibly as little as two to three months. It only puts off the inevitable choice for the EU, which is either a default among some members, with some members leaving, or full fiscal union. The latter would no doubt be accompanied by large cash transfers to stabilize the budgetary situation in the southern euro zone. But until such time that either course is followed, market volatility and investor uncertainty will remain at current levels.

The author thanks Gino Landuyt for editorial assistance with this article

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Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.

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