The writer is chief economist at German bank LBBW
Confronted with the severe shock of the pandemic, eurozone leaders jumped over their shadows and agreed for the first time to issue joint bonds on a massive scale. While the trigger for this revolutionary step was a frightening one, it was accompanied by great expectations. The EU had sold bonds for decades, but it had always been a minnow in the world of supranational issuers.
Before 2020, the outstanding amount of bonds it had issued had not surpassed €50bn, a fraction of its mightier supranational brethren. This changed dramatically with the more than €800bn Next Generation EU programme to support the post-Covid recovery and its smaller cousin, the €100bn SURE programme, which was set up to protect jobs and incomes during the pandemic. Fully implemented, the EU’s outstanding obligations would easily eclipse even the hitherto most prolific supranational borrower, the European Investment Bank.
Armed with top-notch triple A credit ratings, the EU bonds were seen as the previously elusive safe asset that would prop up the euro’s role in international markets, making the common currency a stronger competitor to the dollar.
Since the beginning of this year, all existing and future EU funding programmes have been consolidated under a single EU-bonds umbrella. Size and liquidity are thus further enhanced. Outstanding EU bonds and bills have reached almost €400bn. Secondary market turnover is healthy at about 40 per cent of outstanding volume. Liquidity is thus broadly comparable with EU sovereign bonds.
Alas, the high hopes have not been fulfilled. From the beginning, EU bonds traded more cheaply than those of other European triple A issuers. Even France, rated two notches lower, commands lower borrowing costs than the EU. Initially, the explanation for this relative underperformance of EU bonds was lower liquidity.
If this had been the main reason, the spread with France, as well as Germany, should have gradually narrowed as the supply of EU bonds surged. In fact, the opposite happened. In March 2021, the difference in swap spreads between France and the EU was a negligible 0.06 percentage points. Now, two years later, the spread over France has risen to 0.37 percentage points.
What went wrong? Contrary to sovereign (and other supranational) bonds, NGEU is a one-off programme that has to be fully unwound by the late 2050s. But that was known from the outset. It cannot explain why risk spreads are rising. The reason is more simple. As the surprising show of unity in the face of the pandemic has once again given way to the usual squabbles and quarrels among EU member states, investors have taken a closer look at the EU’s underlying credit strength.
A few features distinguish the EU from other supranational issuers. The bonds are guaranteed by the European Commission. But the commission itself does not have any meaningful revenue sources of its own. Instead, it depends on promises of financial support from its member states, most of which are rated lower than the EU itself. Since there are no cross-default clauses between commission budget contributions and individual sovereign bonds, the likelihood of member states’ budget pledges being paid in time and in full could be lower than the probability of sovereign bonds being honoured.
Other supranationals’ bonds are secured by their loan book. The EU, however, uses a substantial chunk of its issuance to provide grants to member states. At the same time, it is the only supranational that has neither any paid-in capital nor unconditional guarantees.
This makes member states’ budget contributions over the coming decades all the more critical. The EU’s triple A rating implies that a break-up of the bloc, and with it the risk to reliable member states’ budget transfers, is as unlikely as a sovereign triple A default, which historically has been zero even over long periods. In a post-Brexit world, this may be a heroic assumption. Indeed, a poll in 2019 found that about half of EU citizens considered a demise of the EU realistic within 10 or 20 years. This is almost certainly too pessimistic. But impossible it is not.
In short, when stitching together the NGEU programme in record time, European governments may have succumbed to “cakeism”. They devised a structure that provided record amounts of money to themselves without providing the irrevocable financial safeguards capital markets had come to expect. Investors have gradually realised that the EU’s triple A ratings do not reflect its underlying credit characteristics. They trade its securities accordingly.
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