09 October 2018

Vox EU: Turning national growth-indexed bonds into European assets: A proposal to strengthen the euro area

This column, part of the VoxEU debate on euro area reform, proposes the mechanism of a European Debt Agency issuing securitised safe and risky European bonds backed by country-specific growth-indexed bonds for the euro area.

Although there is renewed interest in GIBs in the euro area context, it seems unlikely that they will be issued by individual countries. A main impediment to market development is overcoming the first-mover problem and the stigma associated with it. A joint issuance through securitisation could take care of the problem while reducing the potential premium and allowing countries to issue such bonds at a large scale. 

The mechanism I describe is an extension of the securitisation scheme described by Brunnermeier et al. (2011, 2017) at the euro area level. The coordination of debt issuance can be made by a European Debt Agency (EDA). This agency could be the ESM, an ad hoc entity, or even private financial intermediaries. However, it seems more natural to delegate these operations to a European debt management office. Each country would issue GIBs up to 60% of their own GDP. Above this threshold, countries would continue to issue individual traditional plain-vanilla bonds. 

On its assets side, the EDA buys GIBs from the euro area countries. The buying price of country-specific GIBs should be such that the expected return on a GIB (adjusted for forecasted GDP volatility) is equal to the return on a plain vanilla bond over the maturity of the bond. This guarantees that sovereign risk is not mispriced, and that there is no ex ante redistribution by pooling debt from countries with a low sovereign risk and countries with a higher risk. Thus, this mechanism would still impose some market discipline on highly indebted sovereigns. On its liabilities side, the ESM issues two kinds of bonds: a European safe asset (paying a fixed interest rate) and a European junior asset (paying a variable interest rate). 

Theoretically, by pooling all GIBs and collecting a small premium on national GIBs, the EDA can issue a safe European bond paying a fixed and low interest rate. The junior bonds carry all the GDP risk – the return of junior bonds will depend on the deviations of average euro area nominal growth rates to forecast. To be more explicit, if the average euro area growth is higher than expected then junior bonds pay more (as countries will pay more on their GIBs to the EDA). Conversely, junior bonds pay less if average growth is lower than expected. Moreover, the higher the share of safe asset issuance then the higher the volatility of the return on junior bonds.

The two debt instruments issued by the EDA are more likely to find potential buyers than individual GIBs. On the one hand, the case for a European safe bond is clear and many propositions have already been proposed to create such an instrument (Leandro and Zettelmeyer 2018). On the other hand, this European junior debt could be less risky than country-specific GIBs for two reasons. First, by pooling idiosyncratic risks from different countries, the variance of the return should be lower as growth rates are imperfectly correlated across countries. Second, and more importantly, the fact that the value of junior bonds is indexed to the euro area performance should provide some reassurance to investors that the probability of high losses is limited. Indeed, if the European junior bond pays a lower return, i.e. if the euro area is performing poorly on average, it is more likely that the ECB will decrease its main interest rate (to the extent that down breaks in growth are cyclical rather than structural), which would support the price of the junior bond. 

Conclusion

GIBs are unlikely to substantially decrease the risk of a debt explosion in advanced economies if not issued in a large and coordinated way, which can explain why they have not been issued so far. The proposition introduced in this column may have side effects, andeven in the presence of large growth-indexation of its bond stock, the euro area would still require a backstop for dealing with unsustainable debt cases. Yet, the proposition presents some clear advantages: 

• It allows sovereigns to issue a large share of GIBs while keeping the premium at a low level, thus maximising the benefits from GIBs.
• It offers a fiscal space to countries which need it, and when they need it, while avoiding a mispricing of sovereign risk and ex anteredistribution among European countries.
• It implies the creation of a European safe asset while keeping the junior bond attractive to investors.

The persistent effects of the global financial crisis as well as the current limits on fiscal and monetary policies in advanced economies are forcing us to think about innovative frameworks. The combined used of growth-indexed bonds and securitization could prove fruitful in the euro area context. Going forward, this proposition would also be consistent with a broader rethinking of monetary policy from inflation targeting towards nominal GDP targeting as recently recommended by prominent economists (Summers 2018). 

Full column

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