Will the EU Bond Over Coronabonds?

For several weeks now, 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 bond issuance by all 27 EU member-states. Germany, Austria, the Netherlands and most of northern Europe have long opposed this concept, seeing it as a wealth transfer from fiscally responsible to spendthrift nations. Until Monday, that is, when Chancellor Angela Merkel and French President Emmanuel Macron announced their joint support for a €500 billion coronabond issuance, sending cheers throughout European markets. But the enthusiasm was 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. Regardless of the outcome, however, 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 that led many to see the eurozone as incomplete. After all, most areas that share a currency and monetary policy also share fiscal policy, including transfers from wealthier nations to weaker states. That is how it works in the US, with federal tax revenue and bond proceeds redistributed across all 50 states, as well as the UK, which redistributes revenue from England to Wales, Scotland and Northern Ireland. 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, viewing it as an opportunity to “complete” the currency union, but opposition from several northern European nations rendered the idea of “eurobonds” dead on arrival. Asking their voters to underwrite what many viewed as irresponsible spending on the periphery was a non-starter.

And then came COVID-19, which hit Italy and Spain particularly hard both medically and economically. That naturally heightened calls for a fast, huge fiscal response. But with Italy’s debt finishing 2019 at 135% of GDP and Spain’s at 96%, most 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 euro.^[i] It seems the tragedy of COVID was enough to convince Merkel she could sell this to voters as a sacrifice necessitated by events out of everyone’s control, rather than a bailout of profligate spenders.

Hence, Monday’s agreement, hailed at first as a major breakthrough despite the lack of details. Merkel and Macron’s proposal of €500 billion in EU debt issuance exceeded the European Commissions’ original proposal of €380 billion, which has been making the rounds for three 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 is 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. For one, the EU is notoriously slow at hashing out things like this. As they demonstrated repeatedly during the debt crisis, any proposal of this magnitude requires about 20 rounds of conference calls, summits, side meetings, rewrites, more conference calls, more rewrites, a couple humorous rap videos, three deal collapses and reformations and perhaps an interpretive dance—until a last-minute push seconds before midnight seals the deal. That process usually resulted in grand plans getting watered down or dying on the vine. Two, if recent history is any guide, legal challenges in Germany and the Netherlands will likely cause their high courts to weigh in on joint bond issuance, potentially throwing a big monkey wrench in the plan.

On Tuesday, even more stumbling blocks emerged, sapping much of Monday’s cheer. Where Merkel and Macron initially suggested at least some of the funds would be dispersed to member-states as grants, rather than loans, the Netherlands, Sweden, Denmark, Poland and Austria said they wouldn’t support any grants or other dispersal other than conditional loans—and maybe not even that. As those battle lines were drawn, the timing got fuzzier, as it emerged the proposal would tie bond issuance to the EU’s 2021 – 2027 budget. That means the relief funds wouldn’t hit until next year at the earliest, and probably not all at once, which doesn’t solve the immediate problem of funding a very near-term response.

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

Note, however, that whatever happens, massive bond issuance and spending isn’t a jolt of stimulus that will turbocharge a recovery. As in the US and UK, any such programs are cushions and backstops replacing lost wages and revenues. The biggest economic salve for Spain, Italy and everywhere else is reopening the businesses that were closed to contain COVID-19’s spread. Extra government spending and central bank assistance merely buy time until that happens.

Should the EU eventually agree on those coronabonds and beef up 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 amid austerity—the opposite of stimulus—and grew just fine until COVID containment truncated the expansion. Economies don’t need saviors.