24 May 2012

Paul N Goldschmidt: Deciphering the informal EU Summit

First subject: “Eurobonds” (including “Project Bonds” and EIB financing)

We are aware that President Hollande is “for” and that Chancellor Merkel is “against”! Neither, however, bothers to explain what they mean by “eurobonds”. One vaguely understands that they relate to debentures for which the ultimate redemption obligation is “mutualised” among participating Member States.

Question N° 1:  Who is to be the Issuer?

If it is to be an existing entity, there is, apparently, the choice between the EU itself (EFSM), the ESM, the EFSF or the participating Member States with the guarantee of one or the first three.

To achieve the avowed objective of “mutualisation”, significant changes need to be made to the Treaties establishing the EFSF (in process of being phased out) and the EMS (still in process of ratification). Increasing considerably their/its “fire power” would also be required. Chances on agreement on such an option would be low.

Falling back on the EU itself would require the unanimous agreement of the EU 27 within the framework of new “financial perspectives” with a requalification of the EFSM budgetary line and a significant increase in appropriations.

The option of a totally “new” entity or mechanism should be discarded as it is difficult to imagine yet another Treaty!

Question N° 2: Which legal and credit structure for the Issuer?

Would the “eurobonds” benefit from the joint and several guarantees (mutualisation) of participating Member States? If so, to be credible at least all EMU Members should take part. If not, the project is stillborn!

One must distinguish between the credit structure of the issuer which aims at protecting the investors (guarantees by participants) and the legal position of the issuer with regard to the beneficiaries of its own loans (ranking of reimbursement claims).

A multiplication of issuers would create confusion in the market concerning the legal status of the securities issued by the various euro defence mechanisms which would compete with each other, each having its own specific credit structure; the danger is that interest rates would become aligned on the “community instrument” judged to be the riskiest, penalising the other issuers accordingly.

If the proposal is for each Member State to be responsible for its own issuance but allowing, within clearly prescribed limits, a share of new issuance to benefit from a “European” guarantee, such a formula would imply creating a two-tier market for each issuer. This, in turn, would lead to rate differentials that could become significant between securities issued by the same borrower. Establishing a single European issuer that would “on lend” the proceeds of its fundraising to Member States is clearly preferable. 

Each time a new issuer/instrument is introduced, it is essential to define the ranking of its claims in case of a default of the borrower. Would the issuer of “eurobonds” and other community issuers/lenders (such as the ECB, the EIB, Member States or the IMF) rank pari passu, or would some of them benefit from “privileged creditor status” between themselves as well as in relation to existing public or private creditors? Any privilege benefiting one or several of the lenders would translate in higher borrowing costs for all other lenders (consequence of “subordination” of their claims). 

Question N° 3: What would be the use of funds?

Should it be loans to Member States? In this case, the only reasonable structure would be the creation of an “EU Debt Agency” benefiting from an unqualified EU budget guarantee. This structure would be totally transparent to investors; the EU could protect itself by requiring counter-guarantees from the participating Member States to avoid for others to be in the first line of call as a result of their EU Treaty based joint and several guarantee of any budgetary shortfall. These counter-guarantees would replace the commitments made under the EMS, the ratification and implementation of which could be aborted.

Should it be loans to private entities (infrastructure investments, recapitalisation of the banking sector etc.)? Management of such a programme should be entrusted to the EIB, the only existing Community entity able to manage efficiently major “projects”. The delegation to the Bank can be done in one of two ways (or both): either by an increase of its paid-in or callable capital, increasing commensurately its borrowing and lending capacity and avoiding any need to have recourse to «eurobonds»; or by appointing the Bank as manager of a «Community Agency» financed (“Project bonds”) and guaranteed by the EU budget. A preliminary consensus on this set of options seemed to emerge from the Summit, but it is clearly insufficient to respond successfully to the crisis and would need time before its impact on growth was felt.

Without agreement on these preliminary questions, it is pure fantasy to believe that any possibility of issuance of “eurobonds” exists. The debate, which remained unanswered in Brussels, on whether “eurobonds” should be a precondition or an outcome of fostering deeper European integration remains purely theoretical. Indeed, without a sufficient common disciplinary budgetary framework (golden rule) and efficient enforcement powers (sanctions), the healthier countries will refuse to commit themselves, even if they have the most to lose from the implosion of the EMU/EU.

Second subject: Creation of an EU-wide deposit insurance scheme

This proposal, recently re-actualised by Prime Minister Monti, is aimed at preventing a run on bank deposits, induced by the fears relating to an exit by Greece of the EMU and the possible contagion to other Members. The mutualisation of deposit guarantees at EMU/EU level is unquestionably likely to reduce considerably any panic among depositors. It is, however, only conceivable if, in parallel, there is a significant strengthening in the European regulatory and supervisory framework of the banking sector, correcting the imbedded shortcomings of the de Larosière proposals. The latter ultimately rested nearly all powers with the individual Member States, subjecting them only to an obligation of coordination that always proves difficult to enforce under stressful conditions.

The Monti initiative, broadly consensual, is only likely to see the light of day (as is the eurobond question) if a European “Federalist Project” takes shape; otherwise, its implementation remains highly problematical.

Third subject: The exit of Greece from EMU

However pertinent the analyses of experts may be, one must recognise that no one can predict with any degree of certainty the consequences of a Greek exit from EMU. The “precaution principle” demands therefore that every effort be made to avoid a scenario pregnant with potentially disastrous consequences.

That being said, the attitude of some Greek authorities – backed by advocates of stimulus by further deficit spending or by the sirens of a hypocritical eurosceptical far left – aiming at blackmailing the EU to relieve unilaterally the austerity imposed on the country, is bound to fail, even at the price of an EMU/EU implosion. 

Conclusion

By choosing to postpone any decision until the Summit of the end of June, the Heads of State and Government have taken a huge risk because, in this high stakes game of liar’s poker, markets could be tempted to force decisions without even waiting for the outcome of the Greek vote.

The limited growth prospects and the urgency created by resurgence of the crisis (sovereign debt and banking) as reflected by the nervousness of markets, do, however, offer a unique opportunity to launch a bold political initiative aiming at creating a “EMU Federation” with the broader framework of an “EU Confederation”. The essence of the matter is to affirm the political will to achieve such an ambitious goal rather than to get waylaid in drafting the precise legal contours of the plan.

Without such an orientation, the vain temptation to resort to protectionism at national level will only accelerate the demise of the EMU and ultimately the EU itself.

Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute

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© Paul Goldschmidt