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19 July 2018

Vox EU: Delivering a safe asset for the euro area: A proposal for a Purple bond transition


This column illustrates how a 20-year Purple bond transition could address issues relating to the complexity of splitting the existing sovereign debt stock and concerns on contagion amongst senior and junior debt structures, which impede a single safe asset, and offer a path to genuine Eurobonds.

[...]we propose a 20-year transition that levers on the Fiscal Compact’s requirement to reduce the excess general government debt above 60% of GDP by 1/20 every year. The amount of national sovereign debt consistent with the Fiscal Compact’s annual limit would be labelled ‘Purple’ and protected from debt restructuring under an eventual ESM programme. Any debt above the limit would have to be financed with ‘Red’ debt, that would not benefit from any guarantees. At the end of the 20-year transition period, when Purple bonds will stand at 60% of GDP, these could become genuine Eurobonds as set out in the initial Blue-Red bond proposal by Delpla and von Weizsäcker (2010).

During the Purple bond transition, each member state would continue to issue its own debt and be fully responsible here for. Moreover, the proposal does not require any changes to the existing government debt stock; the only changes required are to the ESM Treaty and the prospectus of the new Red bonds. The characteristics of the Purple bonds should allow this segment of the bond market to price counter-cyclically and remain open for new issuance even when a member state applies for an ESM programme. This, in turn, would lower the eventual financing burden placed on the ESM. Banks, for their part, would hold Purple bonds thus limiting contagion. At the same time, the limits on Purple debt ensure discipline as Red debt would be more expensive to finance. Moreover, the protection against debt structuring only applies under the conditionality of an ESM programme. [...]

Purple bonds offer a path to genuine Eurobonds …

Purple bonds are still a far cry from genuine Eurobonds as there is no joint debt issuance and no joint and several liability. Our proposal does, however, offer a path hereto and importantly, one that avoids the ‘juniorisation’ of any of the existing sovereign debt stock that could otherwise see current bondholders seizing the courts, generating market disruption. Moreover, by gradually restricting the size of Purple debt in line with the Fiscal Compact, moral hazard should be avoided. Indeed, member states that fail to meet the Fiscal Compact goals would be forced to issue the more expensive Red bonds.

To implement our proposal, the ESM Treaty would need to be amended to introduce a no restructuring clause on Purple bonds. There would be no need, however, to alter the existing debt stock contracts which we see as an advantage. The new Red bonds would need to be issued with a clause making it clear that these fall outside the no restructuring clause that our proposal introduces to the ESM Treaty and contain Collective Action Clauses (CACs) to facilitate restructuring if needed. We advise strongly against any automatic debt restructuring rules as these might bring unnecessary disruption and render Red bonds more expensive than fundamentals may warrant.

…and greater stability today than status quo

The question is not just whether Purple bonds offer a politically viable transition to genuine Eurobonds, but also whether they would strengthen the stability of the euro area today compared to the status quo. For this discussion, we need to distinguish between two types of risk; the risk that a member state may be required as part of an eventual ESM programme to restructure its sovereign debt, and the risk that a member state may decide unilaterally to restructure and/or redenominate its debt in the context of a euro exit.

Purple and Red bond prices would converge under euro exit fears

Consider first the risk scenario where the financial market prices in a significant probablity of a euro exit. As detailed in the annex of Bini Smaghi and Marcussen (2018), the pricing of Purple and Red bonds of the member state in question would converge as the two bond types are essentially identical in this case and banks holding these bonds would suffer contagion. We would, however, expect to see less contagion to the sovereign debt of member states where euro exit fears are not present.

Low risk of contagion between Red and Purple debt under an ESM programme

Return now to the case where a member state applies for an ESM programme. Under our proposal, the member state’s Purple bonds would be fully protected from any debt restructuring, thus alleviating investor fears. Furthermore, there should thus be no problem for the ECB to conduct quantitative easing (QE) in these Purple bonds (if such a QE programme is warranted by the overall euro area conditions), to offer an LTRO that the national banks could then use to buy Purple bonds and/or for the ECB to provide support via the OMT programme, given ESM conditionality. As banks would hold only Purple bonds, there would, moreover, be no contagion to banks via their sovereign bond portfolios.

Red bonds would price very differently as these would be subject to restructuring risks and not enjoy the full spectrum of stabilising support from the ECB. As such, Red bond spreads would rapidly deteriorate and the government would lose access to Red bond financing. Given our assumption that the government in question would retain access to the Purple bond market, the ESM programme would only fund the share of debt issuance that would otherwise have been funded by Red bonds. The conditionality of the ESM programme should ensure progress on structural reforms and address unsustainable fiscal policies. This will take time to deliver, but once achieved should allow Red bond markets to re-open.

A point worth note is that at the onset of the Purple bond proposal, the overall cost of funding for government debt should decline, ultimately making it less likely that an ESM programme would be required in the future if governments use this window wisely.

The final point that we make is that as Purple bonds would benefit from the no restructuring guarantee this could allow the ECB to increase the issue limit from the current 33% on such instruments under the QE programme to the 50% awarded to EU supranational bonds. All the more so, if the one-limb CAC proposed by Bénassy-Quéréet al. (2018) is implemented. Given that Purple bonds would still be subject to redenomination risks, it would nonetheless be reasonable to maintain the current risk allocation, where 80% of the risk linked to the Public-Sector Purchase Programme still sits on the national central banks’ balance sheet. Red Bonds would not be eligible for QE. One criticism here is that more QE could result in a further build out of Target II imbalances. The ECB has already made it very clear, however, that any member state leaving the euro area would need to settle such obligations in full.

Full column



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