15 January 2022

Vox: Revising the European fiscal framework, part 2: Debt management

The authors focus on the debt management aspect of their proposal to strengthen the European fiscal framework. They argue for moving a portion of national debts under the umbrella of a European Debt Management Agency,

In a previous column (D’Amico et al. 2021), we discussed a recent proposal regarding changes to the fiscal rules of the Stability and Growth Pact. In this column, we discuss the second element of our proposal: the plan to move a portion of national debts under the umbrella of a European Debt Management Agency (EDA).

In the last decade, there have been many proposals aimed at addressing a basic issue for the EU, namely, the lack of a large central fiscal entity issuing euro-denominated government debt.1 There are various dimensions to this problem, on both the finance and the macroeconomic side, but a common theme is that there is a large potential demand for government-issued, euro-denominated safe assets. The demand for supranational debt is strong even for securities that lack joint and several intergovernmental guarantees and/or a credit enhancement mechanism. Compare, for example, the bonds issued by the European Stability Mechanism (ESM) with those recently issued by the EU in the context of NextGenerationEU (NGEU). The ESM sits on a large amount of paid-in capital, as it could repurchase 70% of its bonds at nominal value. For this reason, it is not surprising that ESM bonds enjoy a AAA rating. The NGEU bonds issued by the EU also attract a AAA rating and trade at prices identical to ESM bonds, even though they are not protected by mutual guarantees or by a cash buffer. What secures the EU bonds in the investors' eyes is solely the EU capacity to extract payments from participating member states.2

This situation hints at an untapped potential for the EU to intermediate debt: moving a share of national tax streams and a share of national debts under the umbrella of a European entity, protected by the enforcement capacity of the EU, can increase the financing capacity of the whole area.

The two main benefits of the plan in our view are: (1) reducing debt costs for the whole Union, and thus increasing the safety of the existing stock of European debt; and (2) helping the operations of the ECB in debt markets. 

In past years, the ECB has taken the main responsibility to ensure the stable functioning of European government debt markets. The creation of a European Debt Agency would complement the ECB's work on the fiscal side. The scheme would favour a gradual shift over time in the composition of the ECB’s assets away from a preponderant exposure to country risk towards a more standard configuration - characteristic of the ECB’s peer central banks – that by and large contemplates holdings of riskless bonds. These benefits could materialise in the near future, if monetary policy required a scaling down of the ECB bond purchase programmes, as it would allow the ECB to proceed in that direction without having to worry about destabilising national debt markets.

Let us briefly summarise the mechanism of the plan and then turn to some questions and criticisms.

Under our proposal, the EDA would gradually purchase a certain amount of national debt, at market prices and in proportion to each country's GDP, and finance the purchase with issuances of EDA debt. At the moment of purchase, the EDA would cancel the country’s bond and replace it with a commitment by the country to pay a flow of contributions to the EDA budget. The contributions would be calibrated to cover the net needs of the EDA associated with managing the debt of each given country, keeping the ratio of debt to country GDP constant, after an initial transition period. The formula to calculate the contributions is (r – g)d, where r is the interest rate on the European debt issued by the Agency, g is the growth rate of the country's GDP, and d is the EDA debt issued in proportion to the country’s GDP. The rate r is the same for all countries and would be chosen conservatively to allow the Agency to accumulate liquid reserves. The rate g would be equal to each country's potential growth (to avoid procyclicality of the contributions). The amount of debt acquired by the EDA for each country would be capped at a level corresponding to the debt increases during the pandemic shock. The contributions would be revised at regular intervals of five years by the EDA’s governing body. The same body would decide how to employ the EDA surplus – whether to save it in reserves, to rebate it to participating countries, or to direct it to joint EU projects.

The gains under the plan come from the expectation that debt issued under the EDA would trade at conditions close to those faced by the safest national debt in the area. This implies that the contributions and the use of the EDA surplus can be designed to yield Pareto gains for all countries involved.3 Where do these gains come from? There are basically three reasons for favourable credit conditions for EU debt. One is that EU debt will earn liquidity and safety premia relative to national debts, as it becomes the reference form of euro-denominated government debt. The second is that the EU will employ its enforcement capacity towards member states to assure investors of the reliability of the flow of future contributions. However, we are aware that there is a third, less desirable, channel, as favourable conditions may also come from an implicit perception of mutualisation, even though the scheme does not imply joint and several guarantees. We believe the scheme should be designed to rely on the two first channels only, while minimising the risk of ‘backdoor mutualization’. This can be done in three ways: by frontloading contributions, choosing a conservative r, and accumulating a liquidity buffer; by considering the use of dedicated sources of fiscal revenue instead of generic contributions; and, last but not least, by embedding the scheme in a solid fiscal governance framework. The last argument clearly points to an important element of complementarity between the two parts of our proposal.4  ...

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