Abstract
This 2012 Article IV Consultation—Selected Issues Paper on Euro Area Policies argues that the creation of a common eurozone financial stability architecture is an immediate priority to restore the viability of the Economic and Monetary Union. The paper presents a narrative of the various stages of the banking and sovereign crisis since the Summer of 2011. It also characterizes the downward spirals at play in periphery euro area countries and describes the process of financial de-integration within the euro area.
II. Fiscal Integration in the Euro Area1
More fiscal integration with stronger governance and more risk sharing can reduce the threat that economic shocks in one country endanger the euro area as a whole. The example of other currency areas suggests that transfers, centralized provision of public goods, or common financial stability backstops can be effective tools to mitigate regional shocks. But risk sharing needs to be anchored in a powerful governance framework that provides for better coordination of fiscal policies and limits moral hazard. The starting point of the euro area is unique, but a clear roadmap towards a fuller fiscal and financial union could anchor expectations. A limited and scalable introduction of common debt with appropriate governance safeguards could support the creation of a banking union and signal a strong intermediate commitment to a fuller fiscal union.
A. The Case for Fiscal Integration in the Euro Area
Adjustment under a common currency
1. In a common currency area, the burden of adjustment to idiosyncratic shocks falls on factor mobility, price flexibility, and supporting financial and fiscal policies. The literature (e.g., Mundell 1961, Kenen 1969) identifies labor and capital mobility, as well as price and wage flexibility as key characteristics for an optimal currency area. Absent exchange rate adjustments, internal flexibility is necessary to absorb economic shocks.
2. Sharing fiscal risks and protecting against negative fiscal externalities are valuable where economic adjustment to country-specific shocks is less than perfect. Where labor mobility is low, intra-area capital flows are volatile, and structural rigidities are impeding price adjustment and reallocation of resources, fiscal and financial policies will have to take on some of the adjustment burden. Risk sharing2 tools can limit the impact of regional shocks and help prevent contagion, and, if accompanied with appropriate governance arrangements, can also safeguard against excessive debt taking of regions.
Where does the euro area stand?
3. Limited labor mobility in the euro area impedes adjustment to idiosyncratic shocks. If workers move in response to differences in wages and job opportunities, they reduce disparities in unemployment rates and real wages across regions (see, e.g., World Bank 2010; Sharpe et al., 2007). However, while there is some evidence that labor mobility in the euro area has increased in response to the crisis, it remains fairly limited. Only about 1 percent of the working age population changes residence within their country in a given year, and even less move between euro area countries. This compares to about 3 percent in the US, 2 percent in Australia, and slightly less than 2 percent in Canada (Figure 1). Obstacles to labor mobility within the euro area include cultural and language barriers, distortions in housing markets, limits to the portability of pensions, and, more generally, the absence of a cross country social safety net.
Labor Mobility in the Euro Area Is Low
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; European Commission; Bonin et al. 2008; and Staff estimates.1/ Mobility within countries.2/ Mobility between countries.Labor Mobility in the Euro Area Is Low
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; European Commission; Bonin et al. 2008; and Staff estimates.1/ Mobility within countries.2/ Mobility between countries.Labor Mobility in the Euro Area Is Low
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; European Commission; Bonin et al. 2008; and Staff estimates.1/ Mobility within countries.2/ Mobility between countries.4. Capital moves freely across the euro area, but is susceptible to sudden swings that challenge financial stability. Free flowing capital can facilitate real convergence in a common monetary area, and promotes the deepening of financial markets. At the inception of the Economic and Monetary Union (EMU), the perceived absence of sovereign risk contributed to rapid financial integration. Cross border credit increased rapidly with capital flowing mainly from the core to the periphery. It was widely considered that the common currency increased integration of financial markets, which would help smooth asymmetrical shocks. But the vulnerabilities that rapid financial integration could harbor were overlooked, as hopes of a “stronger and fitter” banking sector (ECB, 1999) did not materialize. By 2008, however, financial integration reversed its course. Cross border investment positions unwound quickly, core countries became recipients of net private capital flows (Figure 2), and the cross border interbank market became impaired, posing challenges for financial stability.
Private Capital Flows Have Reversed
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Haver Analytics; IFS; and IMF staff calculations.Private Capital Flows Have Reversed
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Haver Analytics; IFS; and IMF staff calculations.Private Capital Flows Have Reversed
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Haver Analytics; IFS; and IMF staff calculations.5. The lack of a common backstop for financial system stability generates adverse feedback loops between the financial sector and sovereigns and fuels contagion.3 Absent strong common regulation, supervision, resolution powers, and deposit insurance, all supported by sufficient supra-national backstops, the integrated financial market makes banking problems hard to prevent and contain. Given the size of national banking systems, the resulting problems can overwhelm the fiscal capacity of individual sovereigns. At the same time, banks have significant exposures to their sovereigns. Consequently, the sharp rise in some sovereign risk premia, often coming on top of rapidly deteriorating macroeconomic conditions, further fuels contagion.
6. Wage and price flexibility in the euro area is limited, slowing the correction of macroeconomic imbalances. Such flexibility is important to guide the reallocation of resources in the event of idiosyncratic shocks. The euro area saw rapid convergence in nominal interest rates since the mid-1990s, but price levels in the periphery picked up more rapidly than in the core. This kept real interest rates at very low levels and fuelled demand in periphery countries. Meanwhile, real convergence lagged behind as wage increases outpaced productivity gains, contributing to large competitiveness gaps and growing current account imbalances (see, among others, Mongelli and Wyplosz, 2009). Even after the crisis began, with few exceptions (e.g., Ireland), prices and wages have not responded strongly to deteriorating macroeconomic conditions, often because of prevalent labor market rigidities (Jaumotte and Morsy, 2012 and Lebrun and Perez, 2011), contributing to a lengthy and costly adjustment process.
Insufficient risk sharing and governance
7. With market adjustment slow or incomplete, weak fiscal governance and lack of fiscal risk sharing are particularly costly. The EU budget is small and was not designed as a risk sharing tool. As a consequence, it provided little help to crisis-hit countries.4 At the same time, the Stability and Growth Pact (SGP) failed to encourage the creation of sufficient fiscal space.5 Estimates suggest that strict adherence to structural targets during 2000-07 would have reduced debt by about 7 percent of GDP by 2007, all other things being equal (Figure 3). As a result, with neither sufficient national buffers nor common backstops available, shocks hitting any one member country could grow into a problem affecting all of the area.
Had Countries Complied with the Medium Term Objectives (MTO)… 1/
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; and IMF staff calculations.1/ Medium Term Objectives are country specific objectives set under the preventive arm of the Stability and Growth Pact (SGP).Had Countries Complied with the Medium Term Objectives (MTO)… 1/
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; and IMF staff calculations.1/ Medium Term Objectives are country specific objectives set under the preventive arm of the Stability and Growth Pact (SGP).Had Countries Complied with the Medium Term Objectives (MTO)… 1/
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: WEO; and IMF staff calculations.1/ Medium Term Objectives are country specific objectives set under the preventive arm of the Stability and Growth Pact (SGP).8. In sum, the euro area can be characterized as an area with incomplete internal adjustment mechanisms and insufficient policy coordination. In particular, the absence of common fiscal and financial policy tools could not compensate for low factor mobility, high nominal rigidity and poor fiscal coordination. And while the crisis brought the introduction of ex-post risk sharing facilities, resort to EFSM/EFSF/ESM is an economically and politically costly way of mutualizing risks after their realization that so far has failed to deliver lasting improvements in confidence and financial conditions.
B. What Makes Currency Areas Viable?
9. Among all the preconditions for a viable currency union, which ones have proved most critical elsewhere? Existing currency areas feature a high degree of fiscal and financial integration, often with strong governance requirements and formalized mechanisms of ex-ante insurance against fiscal and financial risks that prevent contagion. The question is which are essential institutional features that would be worth examining from an euro area perspective.6
Fiscal risk sharing
10. Common backstops for the financial system enhance financial stability. Such frameworks usually include area-wide supervision as well as deposit insurance and resolution frameworks with a common backstop. Besides multiplying the strength of regional backstops, centralized backstops also prevent the emergence of (negative) links between banks and sovereigns. In the U.S., for example, the banking sector is distributed heterogeneously across states, but the Federal Deposit Insurance Corporation (FDIC) insures deposits regardless of the state of registration, and acts to resolve banks countrywide (Figure 4).
Euro Area Banks Are as Large as Their US Counterparts, but Lack a Common Financial Sector Backstop
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: BEA; FDIC; ECB; Eurostat and IMF staff calculations.Euro Area Banks Are as Large as Their US Counterparts, but Lack a Common Financial Sector Backstop
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: BEA; FDIC; ECB; Eurostat and IMF staff calculations.Euro Area Banks Are as Large as Their US Counterparts, but Lack a Common Financial Sector Backstop
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: BEA; FDIC; ECB; Eurostat and IMF staff calculations.11. Risk sharing mechanisms help smooth the impact of macroeconomic shocks. These mechanisms typically include tax sharing arrangements and transfers from the central to regional government, and feature in unitary as well as federal states.
While the institutional arrangements can differ, these transfers typically respond to cyclical developments at the regional level, providing insurance against idiosyncratic shocks as well as to income differences across regions (Figure 5).
Staff analysis finds that, on average, a 1 percent increase in a region’s output gap can lead to an increase in central government transfers offsetting between 5 and 20 percent of the income shock (Box 1). This is consistent with past findings that risk sharing could smooth about 10 to 20 percent of regional income shocks (Melitz and Zumer, 2002; von Hagen, 2007).
Such risk sharing can occur at different frequencies. Indeed, transfer for risk sharing purposes might be difficult to disentangle from “redistributive” transfers aimed at mitigating income differentials: what may look like an attempt to equalize incomes across regions could be the sharing of fiscal risks resulting from slow-moving technological and structural change or gradual shifts in the global environment.7
Elements of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Eurostat; Gracia et al, 2012; and IMF staff calculations.Note: Excludes tax sharing arrangements.1/ For EU, spending of EU budget, data for 2008.2/ Excludes region of Nunavut which receives 77 percent of GDP in gross transfers.Elements of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Eurostat; Gracia et al, 2012; and IMF staff calculations.Note: Excludes tax sharing arrangements.1/ For EU, spending of EU budget, data for 2008.2/ Excludes region of Nunavut which receives 77 percent of GDP in gross transfers.Elements of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Sources: Eurostat; Gracia et al, 2012; and IMF staff calculations.Note: Excludes tax sharing arrangements.1/ For EU, spending of EU budget, data for 2008.2/ Excludes region of Nunavut which receives 77 percent of GDP in gross transfers.Risk Sharing and Redistribution
To assess the potential importance of fiscal risk-sharing through transfers within existing currency areas, this analysis examines the extent to which central government transfers in large federations act as a regional stabilization mechanism. The approach adopts the empirical framework by Rodden and Wibbels (2010) and focuses on gross transfers from the central government. It excludes tax sharing arrangements or other tools of risk sharing such as the central provision of public goods or services.
A panel regression is estimated for a sample of six federations, namely Australia, Brazil, Canada, China, Mexico and the United States. The dependent variable is transfers from the central government to sub-national or regional budgets, expressed as a ratio of state GDP. Two explanatory variables are considered:
where i and t indices denote regions and time, respectively, GDPpc is real per capita GDP, GDPgap is the output gap, α are regional fixed effects, and ε is an error term. Negative and significant coefficients for β1 and β2 quantify the relative weight of each of the factors driving fiscal policy decisions.
In all countries, transfers respond significantly to a variation in the regional output gap, offsetting between 5 and 20 percent of cyclical fluctuations. The hypothesis that gross transfers respond to the level of per capita income in regions is, however, only supported in a couple of federations.
Regression Results
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Source: Gracia et al. (2012).Notes: The estimations are performed using the fixed effects estimator. *, **, and *** denote significance at the 10, 5, and 1 percent levels, respectively. The chart shows the percentage change in federal transfers to state GDP in response to a 1 percentage point decline in a state’s output gap.Regression Results
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Source: Gracia et al. (2012).Notes: The estimations are performed using the fixed effects estimator. *, **, and *** denote significance at the 10, 5, and 1 percent levels, respectively. The chart shows the percentage change in federal transfers to state GDP in response to a 1 percentage point decline in a state’s output gap.Regression Results
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Source: Gracia et al. (2012).Notes: The estimations are performed using the fixed effects estimator. *, **, and *** denote significance at the 10, 5, and 1 percent levels, respectively. The chart shows the percentage change in federal transfers to state GDP in response to a 1 percentage point decline in a state’s output gap.12. In many currency areas, centrally provided goods and services act as an additional insurance against risks. In addition to potential economies of scale, the central provision and financing of public goods and services also entails an element of fiscal risk sharing. This is because during a downturn a region’s relative tax contribution to finance a centrally provided public good or service will fall, while the benefits from these goods and services remain unchanged. Even though the degree of centralization varies reflecting differences in preferences or historical and political developments (Figure 5), central government spending is a significant share of general government in a number of countries.
Strong governance
13. Strong governance helps other currency areas overcome moral hazard. Risk pooling naturally involves moral hazard and many currency areas complement fiscal risk sharing with governance frameworks that limit regional fiscal sovereignty and encourage fiscal behavior in accordance with commonly agreed standards.
A common element of fiscal integration is a center with area-wide tax authority. For example, where public goods are provided centrally, the center usually has some national tax authority over all regions.
Where transfers are a significant part of regional income, the center often has the right to intervene more directly in the regions’ public finances.
Many federations use legally enforceable fiscal rules to ensure that regional fiscal positions are sustainable (e.g., balanced budget rules for states in U.S., the debt brake rule for Germany’s Lander).
14. Risk sharing does not presume no-bailout. Bailout arrangements for subnational or regional entities differ widely across currency areas: they can be formalized, occur ad-hoc, or be explicitly banned (e.g., no-bailout clauses). Where bailout arrangements exist, their deployment combines a loss of regional fiscal sovereignty in return for resources from the center. In other settings, bailout mechanisms are absent. But where no-bailout clauses exist, they are enforced against a background of effective risk sharing that ensures regional risks are mitigated (e.g., through transfers and a common financial sector backstop) and a minimum provision of (centrally provided) public goods and services.
15. In sum, fiscal integration in other currency areas tends to combine risk sharing and governance. Federal and unitary states take different positions along these two dimensions. In unitary states (e.g., France, U.K.) revenue and expenditure policies are determined mostly centrally for the entire territory and, as a consequence, a high degree of fiscal risk is shared. Thus, for regions, external governance is high (or fiscal sovereignty is low). By contrast, federation states (e.g., Germany, Switzerland, and the U.S.) are characterized by a somewhat lower degree of both risk sharing and delegation to the central government. Even lower degrees of risk sharing and external governance exist among confederations where the currency is not common, such as European Union or the Commonwealth of Independent States (see Figure 6 for a stylized illustration).
Dimensions of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Dimensions of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
Dimensions of Fiscal Integration
Citation: IMF Staff Country Reports 2012, 182; 10.5089/9781475505788.002.A002
C. What Are the Options for the Euro Area?
General considerations
16. There are various approaches to designing fiscal integration. One approach would follow the subsidiary principle and allocate all fiscal functions to the central level for which the benefits in terms of economies of scale and positive externalities outweigh the costs. This would have to be matched by adequate financing and democratic accountability.
Functions: A key central function would involve preserving economic stability following idiosyncratic shocks, primarily by insuring regions against fiscal risks, and providing a common backstop of the financial system.
Financing: A sufficiently sized central budget could match specific expenditure programs with centrally controlled sources of taxation or other revenue. Extra-budgetary solutions could be used to finance specific central functions, for example in the financial sector. Common borrowing could be used to support any of these functions but could also offer ways of horizontal risk sharing between regions.
Accountability and governance: With fiscal devolution to the center, democratic accountability would ensure that taxpayers have leverage on policy decisions. At the same time, with moral hazard being part of any insurance or risk-sharing mechanism, strong governance safeguards are needed at the regional level.
17. Making EMU a more viable currency will require more integration, even if convergence towards long term solutions can only happen with time. The starting point of the euro area is unique. The crisis has revealed powerful diverging forces, and while policymakers have responded with bold measures, the viability of the euro area is still being tested. While no readymade blueprint exists, a credible roadmap toward a robust monetary union will have to include intermediate progress toward risk sharing and a substantial reorientation of sovereignty.
Intermediate steps toward risk sharing
18. An effective immediate step towards greater risk sharing would be to provide a common fiscal backstop for a banking union.8 Such a backstop, which could take the form of common debt (see below), would resolve many of the exacerbating factors of the crisis: among other things, it would help break the adverse feedback loops between banks and sovereigns and prevent further financial market fragmentation. To align incentives, delegation of responsibilities (e.g., for deposit insurance or bank resolution) would have to go hand in hand with delegation of oversight (e.g., supervision and resolution) to designated common institutions.
19. Common borrowing could provide such a backstop, ensure market access for sovereigns under stress, and create safe assets for the banking sector. One option would be the introduction of limited and scalable Eurobonds. Among the many proposals discussed (see Table 1 in the Appendix) two are worth particular attention. One temporary approach is to make countries responsible for their own future fiscal policies, using common borrowing only to cover a certain amount of legacy debt, and reestablishing market discipline in the longer term (e.g., the mutualization of debt in excess of 60 percent of GDP as in the European Redemption Fund proposal). Another approach is to start with limited common borrowing (e.g., Eurobills) that could be scaled up in the future. Alternatively, extra-budgetary approaches, for example borrowing for specific purposes, either through established institutions (e.g., the European Investment Bank) or new projects (“project bonds”) could also be considered. However, their benefits are limited because of the small size and low degree of risk sharing they offer.
20. Eurobills and the Debt Redemption Fund go some way in overcoming implementation hurdles associated with changes in national and European law. Common debt issuance can be designed in different ways (see e.g., IMF, 2012), but typically involves far-reaching changes to the current political and legal arrangements in the euro area. Against this background, proposals such as those of Hellwig and Philippon (2011) and the German Council of Economic Experts (2011) can be implemented more expeditiously, and could be a powerful vehicle to build trust:
Eurobills would be joint and several liability instruments with maturity of less than one year, covering up to 10 percent of each country’s own GDP. Participating countries would be unconstrained for long maturities, making Eurobills politically palatable for strong creditors. Participation could be made conditional on meeting fiscal targets. Based on mutual trust, Eurobills could be scaled up and/or their maturity lengthened.
The Debt Redemption Fund implies the gradual transfer of debt exceeding 60 percent of GDP into a fund for which EMU members would be jointly and severally liable. Participating countries would repay its transferred debts within a total of 25 years. The participation in the fund would be conditional on a debt reduction plan and the adoption of structural reforms. To ensure creditworthiness countries would be required to deposit collateral and earmark part of the tax revenues for fulfilling payment obligations.
The need for more governance
21. Regardless of the specific options chosen, the roadmap towards more fiscal integration would also need to spell out the governance requirements. Partial schemes of common borrowing are one safeguard against moral hazard. Other possibilities are collateral mechanisms and stronger centralized governance.
Partial Eurobonds: Tranching under partial Eurobond schemes could mean that countries enjoy lower average borrowing costs, while incurring higher marginal borrowing costs when issuing beyond the common debt framework. This feature of Eurobonds would make it easier to service outstanding debt and at the same time create incentives to reduce debt, and mitigate moral hazard.9 Restricting common debt issuances to short maturities and making participation conditional on fiscal behavior would strengthen incentives not to deviate from agreed consolidation plans debt because debt would have to be rolled over frequently.
Collateral mechanisms: Common borrowing in existing federations is often backed by a federal government with capacity to levy taxes, reassuring investors that debt will be paid back. By contrast, Eurobonds, along the lines discussed above, would have no single treasury to back them—at least in the near future. To overcome the lack of joint fiscal support, participants should commit collateral to guarantee future payments. Present assets and/or future revenues could be used as collateral. Specific (surcharges on) taxes or assets (e.g., currency and gold reserves) could be pledged for that purpose.
Central governance: Recent reforms make stricter oversight of national policies possible.10 Options to further strengthen governance include: time-bound commitments to improve fiscal transparency; the obligation of periodically publishing comprehensive fiscal risk assessments; time-bound commitments to improve budgetary practices, including top-down budgeting, moving to accrual accounting and conducting regular spending reviews; and the consent to annual auditing of public accounts conducted by independent parties.
D. Conclusions
22. A more viable EMU involves more fiscal and financial integration. In view of low labor mobility and volatile capital flows, the euro area needs to embrace fiscal and financial policies that entail a higher level of risk sharing to respond more effectively to idiosyncratic regional shocks. Greater fiscal integration would help centralize macroeconomic and financial stabilization, provide ex ante insurance against risks, and this would also signal strong commitment to making EMU a closer union.
23. Although getting to the endpoint of fiscal integration will take time, intermediate steps should be considered. The limited but scalable introduction of common debt, with appropriate governance safeguards would help break the adverse feedback loop between banks and sovereigns, support the development of a banking union, and be a step towards a closer fiscal union.
Proposals for Common Euro Area Sovereign Debt: Main Features
Proposals for Common Euro Area Sovereign Debt: Main Features
| Eurobills Hellwigh/ Philippon (2011) | European Redemption Pact German Council of Economic Experts (2011) | Blue/Red Proposal Delpla / Von Weizsäcker (2010) | ESBies Brunnermeier et al. (2011) | Stability Bonds European Commission Green paper | |||
|---|---|---|---|---|---|---|---|
| Full joint and several liability (JSL) | Partial joint and several liability (JSL) | Several liability | |||||
| Concept | Eurobills JSL with maturity of less than one year; countries give up their right to issue short term debt; Scale up and/or lengthen maturity later to evolve into Eurobonds | Gradual transfer of debt exceeding 60 percent of GDP into fund alongside payment obligations such that each country repays its transferred debts within 25 years | Blue bonds are JSL; red bonds are any national debt beyond a country’s blue bond allocation | Securitization of existing sovereign debt into a safe tranche (€3.8 trillion) and a risky tranche (€1.7 trillion); new securities are not JSL | Euro Area sovereign debt is fully covered by JSL bonds | JSL bonds replace a limited portion of national issuance | Stability bonds underpinned by pro-rata guarantee partially replace national issuance; ESM is kept as a separte issuer for emergency financing |
| Principal objectives | Reduce liquidity risk premia; sever the banking-sovereign feedback loop | Serve as bridge to a long-term stability structure ensuring adherence to FC and SGP, create safe asset by issuing own bonds covering the participating countries’ refinancing requirements during roll-in phase. | Achieving both higher and lower yields at the same time. Higher yields are early signal to irresponsible fiscal behavior. Lower yields desirable to reduce the cost of debt for taxpayers | Create a large pool of safe assets ; sever the banking sovereign-feedback loop; stabilize and diversify capital flows | (To varying degrees depending on the scheme) Alleviate liquidity constraints of distress sovereigns; reduce liquidity risk premia; assure high quality collateral for financial institutions; promote international role of the € | ||
| Seniority | Eurobills are senior to other debts | Unspecified | Blue bonds are senior to red bonds; red bonds take the hit of default | Safe tranche is senior; risky tranche takes the hit of default | Only one class of bonds available in the market | Senior to national debt | Senior to national debt |
| Life span | Non open-ended commitment | Self unwinding when debt is redeemed (20-25 years) | Open-ended commitment | Non open-ended commitment | Open-ended commitment | Open-ended commitment | Open-ended commitment |
| Funding degree | Up to 10 percent of Euro Area GDP (= US Treasury billsshare in of US GDP) | Debt of EMU countries exceeding 60 percent of GDP, around EUR 2.3 trillion. | JSL up to 60 percent of each country’s GDP, national debt for the remainder | Up to 60 percent of Euro Area GDP. The weight of each country’s debt is equal to its share in the Eurozone’s GDP. Some adjustment to sovereign risk could be considered | 100 percent of Euro Area GDP | Quotas linked to policy compliance. No optimal calibration suggested | Unspecified |
| Authors’ perspective on the legality | No Treaty change | No treaty change | Treaty change | No Treaty change | Treaty change | Treaty change | No Treaty change |
| Institutional set-up | A joint debt management office (DMO) allocates bond quota and issues Eurobills | European redemption fund to issue debt covering financing needs of participating countries up to cap | An independent stability council (ISC) allocates bond quota, countries issue themselves; allocations proposed by ISC are voted on by natinal parliaments | A debt agency buy on the secondary market sovereign debt | While countries could issue SBs on a decentralised basis, creating a single euro-area DMO would be more efficient. On who would play this role, it is suggested (i) a new DMO could be created; (ii) the EFSF/ESM could become a full-scale DMO; (iii) the EC acts as DMO | ||
| Participation | All Euro Area countries | All non-program Euro Area countries | Voluntary, but opting out is a bad signal | All Euro Area countries | All Euro Area countries | All Euro Area countries | All Euro Area countries |
| Calculation of rates | Market determined rates | Market determined rates | Market determined rates | Market determined rates | While yields on SBs would be market-based, funding costs might be | ||
| Likely gains | No quantification provided | Financing costs can be expected to fall within a range of around 2.5-3 percent. But higher yields also seem possible given market uncertainty at present. | 30 basis point reduction in the liquidity premium | Based on conservative assumptions, default of the safe trance unlikely. ESBies would thus command a yield similar to German bonds; junior tranche would yield about 6 percent | Large reduction in liquidity premium; no estimates provided | Medium reduction in liquidity premium; no estimates provided | Lower liquidity effect; no estimates provided |
| Costs | Eurobills only take over short end of market. No further quantification provided | Bonds issued by the DRF would be comparable to Bunds in terms of liquidity and default risk, but there would be no currency risk left. Germany’s refinancing costs would thus rise to between 2.5-3 percent. | No quantification provided | Even AAA rated countries could gain substantial amounts from these liquidity improvements. No quantification provided. | Strong shift of benefits from higher to lower rated countries | Smaller shift of benefits from higher to lower rated countries | No impact across countries |
| ECB’s role | ECB not meant to buy Eurobills. If it does, countries must repurchase them within one quarter | Unspecified | Unlike blue bonds, red bonds are not accepted by ECB as collateral | ECB accepts safe tranche as collateral | ECB accepts SBs as collateral | ||
| Moral hazard | Short maturity means credible seniority and easy monitoring | Low due to governance safeguards | The bligation to introduce CACs for red bonds facilitates orderly defaults, increases the marginal cost of public borrowing, and enhances fiscal discipline | With ESBies, the guarantee is provided by the pool of bonds, not by any future fiscal revenues as with Eurobonds. Moral hazard does not apply | High | Medium, but coupled with market incentives for fiscal discipline | Low, but stronger market incentives for fiscal discipline |
| Conditionality | Participation in Eurobills emissions is conditional on budgetary discipline | Continued participation in the fund conditional implementing debt reduction plan. | Countries with credible fiscal policies are allowed to borrow up to the full 60 percent of GDP; weaker fiscal performers borrow a lower proportion of GDP in blue Bonds | Unlike Eurobonds, ESBies to not require tight fiscal policy coordination among countries | Increased surveillance and instrusiveness in the design of national fiscal policies; seniority of debt service over any other spending; failing countries could be put under some form of “administration” | ||
| Transition to new regime | Eurobills phased in as soon as DMO is created | Roll in phase is part of the design | All the legacy government debt is senior to the red debt but junior to the blue debt. Legacy debt would be gradually replaced by the blue and red tranches. The transition should in effect be completed after a decade | A target of issuing 60 percent of Euro-Area GDP would be reached via monthly issues over 5 years | Both accelerated and gradual phase-in are possible. Accelerated schemes allow for quick materialization of benefits but pose higher risk to market disruption | ||
Proposals for Common Euro Area Sovereign Debt: Main Features
| Eurobills Hellwigh/ Philippon (2011) | European Redemption Pact German Council of Economic Experts (2011) | Blue/Red Proposal Delpla / Von Weizsäcker (2010) | ESBies Brunnermeier et al. (2011) | Stability Bonds European Commission Green paper | |||
|---|---|---|---|---|---|---|---|
| Full joint and several liability (JSL) | Partial joint and several liability (JSL) | Several liability | |||||
| Concept | Eurobills JSL with maturity of less than one year; countries give up their right to issue short term debt; Scale up and/or lengthen maturity later to evolve into Eurobonds | Gradual transfer of debt exceeding 60 percent of GDP into fund alongside payment obligations such that each country repays its transferred debts within 25 years | Blue bonds are JSL; red bonds are any national debt beyond a country’s blue bond allocation | Securitization of existing sovereign debt into a safe tranche (€3.8 trillion) and a risky tranche (€1.7 trillion); new securities are not JSL | Euro Area sovereign debt is fully covered by JSL bonds | JSL bonds replace a limited portion of national issuance | Stability bonds underpinned by pro-rata guarantee partially replace national issuance; ESM is kept as a separte issuer for emergency financing |
| Principal objectives | Reduce liquidity risk premia; sever the banking-sovereign feedback loop | Serve as bridge to a long-term stability structure ensuring adherence to FC and SGP, create safe asset by issuing own bonds covering the participating countries’ refinancing requirements during roll-in phase. | Achieving both higher and lower yields at the same time. Higher yields are early signal to irresponsible fiscal behavior. Lower yields desirable to reduce the cost of debt for taxpayers | Create a large pool of safe assets ; sever the banking sovereign-feedback loop; stabilize and diversify capital flows | (To varying degrees depending on the scheme) Alleviate liquidity constraints of distress sovereigns; reduce liquidity risk premia; assure high quality collateral for financial institutions; promote international role of the € | ||
| Seniority | Eurobills are senior to other debts | Unspecified | Blue bonds are senior to red bonds; red bonds take the hit of default | Safe tranche is senior; risky tranche takes the hit of default | Only one class of bonds available in the market | Senior to national debt | Senior to national debt |
| Life span | Non open-ended commitment | Self unwinding when debt is redeemed (20-25 years) | Open-ended commitment | Non open-ended commitment | Open-ended commitment | Open-ended commitment | Open-ended commitment |
| Funding degree | Up to 10 percent of Euro Area GDP (= US Treasury billsshare in of US GDP) | Debt of EMU countries exceeding 60 percent of GDP, around EUR 2.3 trillion. | JSL up to 60 percent of each country’s GDP, national debt for the remainder | Up to 60 percent of Euro Area GDP. The weight of each country’s debt is equal to its share in the Eurozone’s GDP. Some adjustment to sovereign risk could be considered | 100 percent of Euro Area GDP | Quotas linked to policy compliance. No optimal calibration suggested | Unspecified |
| Authors’ perspective on the legality | No Treaty change | No treaty change | Treaty change | No Treaty change | Treaty change | Treaty change | No Treaty change |
| Institutional set-up | A joint debt management office (DMO) allocates bond quota and issues Eurobills | European redemption fund to issue debt covering financing needs of participating countries up to cap | An independent stability council (ISC) allocates bond quota, countries issue themselves; allocations proposed by ISC are voted on by natinal parliaments | A debt agency buy on the secondary market sovereign debt | While countries could issue SBs on a decentralised basis, creating a single euro-area DMO would be more efficient. On who would play this role, it is suggested (i) a new DMO could be created; (ii) the EFSF/ESM could become a full-scale DMO; (iii) the EC acts as DMO | ||
| Participation | All Euro Area countries | All non-program Euro Area countries | Voluntary, but opting out is a bad signal | All Euro Area countries | All Euro Area countries | All Euro Area countries | All Euro Area countries |
| Calculation of rates | Market determined rates | Market determined rates | Market determined rates | Market determined rates | While yields on SBs would be market-based, funding costs might be | ||
| Likely gains | No quantification provided | Financing costs can be expected to fall within a range of around 2.5-3 percent. But higher yields also seem possible given market uncertainty at present. | 30 basis point reduction in the liquidity premium | Based on conservative assumptions, default of the safe trance unlikely. ESBies would thus command a yield similar to German bonds; junior tranche would yield about 6 percent | Large reduction in liquidity premium; no estimates provided | Medium reduction in liquidity premium; no estimates provided | Lower liquidity effect; no estimates provided |
| Costs | Eurobills only take over short end of market. No further quantification provided | Bonds issued by the DRF would be comparable to Bunds in terms of liquidity and default risk, but there would be no currency risk left. Germany’s refinancing costs would thus rise to between 2.5-3 percent. | No quantification provided | Even AAA rated countries could gain substantial amounts from these liquidity improvements. No quantification provided. | Strong shift of benefits from higher to lower rated countries | Smaller shift of benefits from higher to lower rated countries | No impact across countries |
| ECB’s role | ECB not meant to buy Eurobills. If it does, countries must repurchase them within one quarter | Unspecified | Unlike blue bonds, red bonds are not accepted by ECB as collateral | ECB accepts safe tranche as collateral | ECB accepts SBs as collateral | ||
| Moral hazard | Short maturity means credible seniority and easy monitoring | Low due to governance safeguards | The bligation to introduce CACs for red bonds facilitates orderly defaults, increases the marginal cost of public borrowing, and enhances fiscal discipline | With ESBies, the guarantee is provided by the pool of bonds, not by any future fiscal revenues as with Eurobonds. Moral hazard does not apply | High | Medium, but coupled with market incentives for fiscal discipline | Low, but stronger market incentives for fiscal discipline |
| Conditionality | Participation in Eurobills emissions is conditional on budgetary discipline | Continued participation in the fund conditional implementing debt reduction plan. | Countries with credible fiscal policies are allowed to borrow up to the full 60 percent of GDP; weaker fiscal performers borrow a lower proportion of GDP in blue Bonds | Unlike Eurobonds, ESBies to not require tight fiscal policy coordination among countries | Increased surveillance and instrusiveness in the design of national fiscal policies; seniority of debt service over any other spending; failing countries could be put under some form of “administration” | ||
| Transition to new regime | Eurobills phased in as soon as DMO is created | Roll in phase is part of the design | All the legacy government debt is senior to the red debt but junior to the blue debt. Legacy debt would be gradually replaced by the blue and red tranches. The transition should in effect be completed after a decade | A target of issuing 60 percent of Euro-Area GDP would be reached via monthly issues over 5 years | Both accelerated and gradual phase-in are possible. Accelerated schemes allow for quick materialization of benefits but pose higher risk to market disruption | ||
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Prepared by Helge Berger (EUR), Fabian Bornhorst (EUR), Esther Perez-Ruiz (EUR), Jimmy McHugh (FAD), and Tigran Poghosyan (FAD).
In this context, risk sharing broadly includes those risks stemming from short term idiosyncratic real and financial shocks as well as those associated with financial instability and slow structural adjustment.
See The Eurozone Crisis and the Sovereign-Bank Nexus: The Case for a Eurozone Banking Union, Euro Area 2012 Article IV Consultation: Selected Issues.
The EU budget collects contributions from and allocates funds to member states according to rules, for example, the EU common agriculture and cohesion policies (from the expenditure side) and the current system of contributions based on the VAT and GNI resources (on the revenue side). The allocation principles in the common EU budget reflect primarily regional and redistribute concerns, not necessarily fiscal risk sharing.
Much of this was recognized early on. See Bornhorst and others (2012) for a review of the early literature on the euro area. For example, Bordo and Jonung (1999) review the formation of currency areas and conclude that, more often than not, political considerations explain the introduction of common currencies before the economic criteria for an optimal currency area fulfilled.
For related discussions see, among others, Bordo et al. (2011) and Henning and Kessler (2012).
For example, within Germany’s fiscal equalization scheme some Länder have been net beneficiaries for many decades before becoming net contributors and vice versa, reflecting for the most part structural change.
For a full discussion, see The Eurozone Crisis and the Sovereign-Bank Nexus: The Case for a Eurozone Banking Union, Euro Area 2012 Article IV Consultation: Selected Issues Paper.
It has been argued that Eurobonds are one application of the Modigliani-Miller theorem, which says that the value of a firm is not affected by the way its liabilities are structured, limiting the gains to be realized by common debt. However, if joint and several guarantees succeed in shielding countries from being pushed into a bad equilibrium, the underlying risk of participants would decline.
Fiscal governance is being upgraded since 2011 around the “six pack”, the Fiscal Compact, and the “two pack” (see Fiscal Consolidation under the SGP: Some Illustrative Simulations, Euro Area 2012 Article IV Consultation: Selected Issues).
