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Europe ponders options for fiscal integration

The prolonged sovereign debt crisis in Europe has left many doubting the single currency can ever work without deeper fiscal union, and the creation of the so-called European Redemption Fund. If Germany agrees to pick up the tab – the only crisis circuit-breaker in town if the ECB sticks strictly to its mandate – here’s how the pooling of liabilities might work.

In 2010, Bruegel, the European economic think-tank, introduced innovative proposals for a eurozone fiscal union. In particular, it favoured the blue-bond concept: 60% of the eurozone’s sovereign debt should be pooled as blue bonds, jointly guaranteed by all participating eurozone countries and given senior status. The remaining national debts would be designated as red bonds and given junior status. The resulting blue-bond asset class would be larger and more liquid even than the Bund market, reducing borrowing costs across Europe, Bruegel said. It was argued the plan would increase fiscal discipline on the periphery, with increased market sensitivity on the 40% of debt that remained in national hands.

However, a eurozone fiscal union is seen as the kiss of death for governments in many core countries, principally Germany, amid seething discontent at the suggestion the country’s taxpayers should bankroll the perceived profligacy of the periphery.

The solution to this concern, a time limit on the plan, would confine blue-bond issuance to shorter durations, undermining the plan’s effectiveness.

Some also worried it would undermine liquidity for red bonds, increasing rates and potentially exacerbating the problems the plan sought to solve.

In 2011, the German Council of Economic Advisers drafted a new proposal, for a European Redemption Fund (ERF), addressing some of the concerns about the blue-bond concept.

The origins of the proposal can be found in the precedent set by the American Alexander Hamilton, who created a similar fund in the 1790s to clear up the economic mess after the War of Independence, says Kim Asger Olsen, partner at Origo Asset Management, a global macro hedge fund.

In some ways it is the mirror image of the earlier idea: this time all debt over 60% of national GDP is placed in the fund, which is further equipped with a joint eurozone guarantee. The debt is converted into 20- to 30-year bonds and repaid by countries according to how much debt they transferred in.

The calculation would be consistent with a repayment schedule lasting 20 to 25 years. The fund would have a mechanism to ensure no country can issue new debt without the approval of other member states.

Because the fund would be temporary, it would be more politically palatable to Germany, though one perceived obstacle to the plan is that by increasing the supply of perceived safe assets, the ERF would undermine the status of Bunds and increase rates on German debt.

Yet any solution alleviating pressure on the periphery implies some measure of pain for the core.

The resulting triple-A asset class would be highly liquid, and the gain for the eurozone as a whole would far outweigh the pain on the few core countries where borrowing costs might rise, says Zsolt Darvas, research fellow at Bruegel, a Brussels-based economic think tank.

The result would be limited debt mutualization, with more than half of each country’s debt being serviced at the same rate across the eurozone, at a considerably lower cost than the average of the current bond yields in the eurozone.

It would mean core countries, such as Germany, Benelux and Finland, pay higher interest on the 60% than on the rest, while peripherals pay less.

“Sober estimates point to extra debt service cost for Germany in the first year of some €50 billion, and considerably less in the following years,” says Olsen.

The deal excludes Greece, Ireland, Portugal and Cyprus, because they have existing European assistance programmes in place – although if Ireland exits its assistance programme this year, it too could join – but would include Spain and Italy, seen as the biggest threats to eurozone stability.

The ERF remains just one option for gradually increased fiscal integration on the table. Another envisages the merger of short-term debt for up to 10% of the GDP of participating nations, which goes even further in addressing the political objections of core Europe.

By limiting cooperation to debt with two-year durations, it would be easier to expel countries failing to meet their responsibilities in reducing public debt. Considerably less ambitious in scope, the plan would be less transformational for the periphery, but still be a step in the right direction, says Darvas.

The other popular option is to continue to muddle through, and few would bet against European politicians again taking their favourite option.

Last year, German chancellor Angela Merkel ignited global optimism that the eurozone could stumble towards a long-term solution to financial instability by suggesting joint Eurobonds could be issued but only once a more solid architecture has been established in Europe, a radical departure from her previous rejection of all mutualization plans. However, if Europe waits for things to improve before contemplating fiscal integration, the perceived need for a solution will have declined, meaning the chance of action is reduced.

Failure to take action will confine Europe to sluggish growth for years to come, warns Darvas.

Critics note the ERF would do nothing to directly resolve the crises in banking or the balance of payments, or the lack of competitiveness plaguing much of Europe.

Many also doubt periphery countries would be able to meet the preconditions. Neither Spain nor Italy looks likely to even stabilize their public debt levels, let alone reduce them to the levels envisaged by the ERF.

And the threat of expulsion sounds hollow, because it would likely mean a restructuring for that country, triggering a wave of contagion thanks to interlocking debts.

Yet optimists hope the severity of the implications of expulsion would instead motivate the periphery to act. “The ERF can work only with giving up fiscal sovereignty, which should ensure that fiscal targets are met,” concludes Darvas. 

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