11 May 2012

Fonseca/Santa-Clara: Euro-coupons - Mutualise the interest payments, not the principal

Eurobonds have been proposed as a solution to the crisis, but Germany is wary of guaranteeing the entire debt of eurozone countries. This column suggests the more politically feasible euro-coupon solution. Eurozone countries would issue bonds at market interest rates, and transfers between countries would harmonise the effective interest rates.

The authors propose a simpler alternative that does not have this drawback but will still move the periphery from the bad to the good equilibrium. Countries would continue to issue bonds separately, at whatever interest rates are demanded by investors, as compensation for their perceived risk of default. The authors would compute the average of all the coupon rates weighted by the amounts issued by each country. Then, countries that paid a coupon rate lower than this weighted average would transfer the difference to countries that issued at a higher rate. They term this the euro-coupon solution.

All eurozone countries would effectively be issuing new debt at the same interest rate. In this way, we would get out of the self-fulfilling bad equilibrium since a country’s high interest rate would no longer increase its likelihood of default.

However, there would still be the possibility of default by countries with unsustainable debt levels, even at the pooled interest rate. Crucially, this risk would be fully borne by investors, not by the other countries in the union.

Illustration of the costs

As a simple illustration, imagine that all the countries in the eurozone issued the amounts expected this year at the current respective 10-year yields:

• Germany would issue at a coupon rate of 1.8 per cent and Spain at 5.2 per cent.
• The weighted average of the coupon rates off all countries would be 3.5 per cent.

Under the authors' euro-coupon scheme:

• Germany would then transfer the difference between 3.5 per cent and 1.8 per cent times the amount issued to the central pool; and
• Spain would receive the difference between 5.2 per cent and 3.5 per cent times the amount issued from the central pool.

This corresponds roughly to transfers of €5 billion from Germany, which issues 24 per cent of all the debt in the eurozone, and €3 billion to Spain, which has a share of 19 per cent of total debt.

Moral hazard

Of course this scheme does not solve the moral hazard problem of over-issuance of debt. Countries would be tempted to run up debt since they don’t have to bear the full cost of their profligacy. This means:

• we would still need policies like the recent Fiscal Compact to limit budget deficits or the total amount of debt;
• unlike eurobonds, under the euro-coupon plan, market-set interest rates for each country would still be observable – a useful signal for policymakers.

In this way, the euro-coupon scheme provides a large incentive to eurozone members to monitor each other’s debts, since all are affected by any member’s higher interest rates.

Finally, countries would need to coordinate their bond issuance to sell bonds with the same maturities in the same proportion at the same time. So the Treasury function would have to be centralised to some extent.

Conclusion

The euro-coupon scheme could represent a decisive step towards restoring confidence in the eurozone. Once investors realise that no country would again be dragged into a negative spiral of higher deficits driven by higher interest costs, the spreads between the different countries would narrow, making the solidarity implied in the scheme less onerous.

Regarding feasibility, remember that in the euro-coupon scheme Germany does not guarantee the capital or even the coupons of the Spanish bonds. It only commits to transfer the difference between its actual financing costs and the theoretical common costs (weighted average) of the currency union. While this would seem impossible in normal times, it may actually be Germany’s cheapest way of putting an end to the crisis. After all, the alternative may be hundreds of billions more in public loans to failing southern nations.

Euro-coupons achieve much the same benefits as eurobonds with only a fraction of the political difficulty.

Full article

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