Did the EU Just Agree to Collectivised Debt?

For several weeks, France and several southern European nations have argued the only way to fund the EU’s fiscal response to COVID-19 without sending Italy and others into a debt crisis is to issue so-called coronabonds—joint debt issued by all 27 EU member-states as a singular entity. Germany, Austria, the Netherlands and most of northern Europe have long opposed this concept, frequently portraying it as a wealth transfer from fiscally responsible to spendthrift nations. But on Monday, German Chancellor Angela Merkel and French President Emmanuel Macron announced their joint support for a €500 billion coronabond issuance, which European markets appeared to welcome by rallying almost 5%.^[i] But the enthusiasm seemed short-lived, as the deal’s many caveats and a raft of opposition emerged on Tuesday. The debate probably won’t resolve soon, and even if the deal goes through, the proceeds won’t be an immediate benefit, in our view. Regardless of the outcome, however, we think an EU economic recovery likely doesn’t hinge on coronabonds.

Though the name “coronabonds” is new, the concept of pooled EU or eurozone debt isn’t. Member-states considered the concept but rejected it when the euro was born, preferring to have a monetary union without a fiscal transfer union—a unique arrangement. Most areas that share a currency and monetary policy also share fiscal policy (e.g., government spending, taxation and federal debt issuance), including transfers from wealthier regional governments to weaker ones. That is how it works in the UK, which redistributes revenue from England to Wales, Scotland and Northern Ireland. Similarly, the US redistributes tax revenue and government debt proceeds across all 50 states. The EU, by contrast, has always had a limited budget funded by pre-set contributions from member-states, and that budget is mostly for operational and development purposes, not transferring funds to national budgets. Some eurozone member-states sought to change that during the 2011 – 2013 sovereign debt crisis, but opposition from several northern European nations prevented it from moving forward. Asking their voters to underwrite what many constituents viewed as irresponsible spending on the periphery didn’t appear politically viable.

When COVID-19 hit Italy and Spain hard both medically and economically, that heightened calls amongst financial commentators and national leaders for a fast, huge fiscal response. But with Italy’s debt finishing 2019 at 135% of gross domestic product (GDP, a government-produced measure of economic output) and Spain’s at 96%, many financial commentators we follow presume neither has the bandwidth to borrow a few hundred billion extra euros this year without causing a new debt crisis that could risk splintering the eurozone.^[ii] It seems the tragedy of COVID was enough to convince Merkel she could present this to voters as a sacrifice necessitated by events out of everyone’s control, rather than a bailout of profligate spenders.

Initially, Merkel and Macron’s proposal generated enthusiasm despite its lack of details. Their proposed €500 billion in EU debt issuance exceeded the European Commission’s original proposal of €380 billion, which had been circulating in the news for months. Proceeds would beef up the EU’s budget, and interest payments would come from higher budget contributions from member-states. Each member-state’s budget contribution would be proportional to its size, but the COVID relief would be doled out according to each member-state’s need—a revenue transfer from north to south in all but the name.

From the start, the enthusiasm seemed overwrought to us. For one, the EU is typically slow at implementing major institutional and financial reforms like this, which generally require unanimous member-state approval. Two, recent history suggests legal challenges in Germany and the Netherlands will likely cause their high courts to weigh in on joint debt issuance, potentially disrupting the plan’s main ambitions.

On Tuesday, even more stumbling blocks appeared to emerge, sapping much of Monday’s cheer. Where Merkel and Macron initially suggested at least some of the funds would be disbursed to member-states as grants rather than loans, the Netherlands, Sweden, Denmark, Poland and Austria said they wouldn’t support any grants or disbursements other than conditional loans—and maybe not even that. Plus, further details on the proposal tied debt issuance to the EU’s 2021 – 2027 budget. If so, that means the relief funds wouldn’t be disbursed until next year at the earliest, and probably not all at once, which wouldn’t solve the immediate problem of funding a very near-term response.

We won’t predict how this goes, other than say that the debate likely lingers for several months. In the meantime, if Italy and Spain need to increase debt issuance to fund their national responses to COVID and the economic contraction, the evidence suggests they can do so without breaking the bank. Whilst their high debt-to-GDP ratios feature in the financial news, those figures aren’t terribly meaningful, in our view. Countries don’t pay debt with GDP, which is an annual flow of economic activity. Rather, they repay maturing debt by issuing new debt securities, and they pay interest with tax revenues. So, in our view, the more relevant question is, are Italy and Spain’s interest costs presently low enough that they can add more without jeopardising their ability to pay? We think so. Last year, Italy’s interest payments cost 12.4% of tax revenues.^[iii] Spain’s cost 13.6%.^[iv] Both have fallen quite a bit in recent years as ultra-low long-term rates allowed them to refinance maturing debt at lower yields.^[v] They are still doing so. In late April 2010, Italy issued 10-year debt at 4%.^[vi] Last month, they effectively refinanced those at 1.35%.^[vii] Similarly, Spain’s 10-year debt issued in late May 2010 fetched an average 4.1% yield.^[viii] Unless something shifts radically, considering Spain’s 10-year debt presently yields 0.82%, they should also be able to refinance at a steep discount.^[ix] In our view, if ever there was a time to issue a chunk of unplanned debt, when markets appear hungry for stability and yield, that time is now.

Note, however, that whatever happens, we don’t think massive debt issuance and spending is a jolt of stimulus that will turbocharge a recovery. As in the US and UK, any such programmes are mostly cushions and backstops replacing lost wages and revenues. In our view, the biggest economic salve for Spain, Italy and everywhere else is reopening the businesses that were closed to contain COVID-19’s spread. We think extra government spending and central bank assistance merely buys time until that happens.

Should the EU eventually agree on those coronabonds and increase its budget by €500 billion next year, it is possible that this could serve as a smidge of stimulus, depending on how the funds are spent. But this is unknowable today, and we don’t recommend factoring the possibility into your investment decision-making. The EU and eurozone emerged from the debt crisis’s associated recession (extended economic contractions, often defined as two or more consecutive negative quarterly GDP readings) amid austerity—the opposite of stimulus—and grew just fine until COVID containment truncated the expansion.^[x] Economies don’t need saviours, in our view.