MacroScope

Eurobond or bust

May 29, 2012

Many market analysts consider a deeper fiscal union the only way to hold together a troubled euro zone. And while Germany continues to loudly reaffirm its long-standing opposition to shared euro zone bonds, the region is in many ways already headed towards implicit mutual responsibility for national debts. Berlin will likely come under increasing pressure to succumb, especially now that “core” European countries are entering the crosshairs of speculators .

The region’s complex TARGET2 payments system, which hosts payment flows between euro zone member states, suggests there is already a good deal of risk-sharing implicit in regional structures, not to mention the exposure the European Central Bank has to peripheral debt. That shared liability may fall short of the kind of joint risk-taking foreseen for a common bond, where one country is responsible for the non-payment of debt by another.

But analysts say the build-up of imbalances in the system – as the ECB replaced private sector lending which dried up for peripheral countries – reflects the latest in a number of crisis-fighting steps that have increased regional integration.

The tab Greece and other indebted euro zone members are accumulating at the Bundesbank via the ECB illustrates how intertwined Germany’s fate has become with those of peripheral states.

Elwin de Groot, senior market economist at Rabobank, says:

As these assets or claims and liabilities vis-a-vis other member states grow, it means you get more and more involved in each other’s business and that’s basically the same as saying that you are gradually moving towards a fiscal union.

During the crisis Greece, Ireland, Italy, Portugal and Spain built up the bulk of the 644 billion euros worth of Bundesbank IOUs in the region’s cross-border TARGET2 system.

Economists say the imbalances would only become a problem if one or more countries leave the euro. But if a member state does exit and its central bank is not able to honour its liabilities with the ECB, the cost could end up with the rest of national central banks. Meanwhile, the prospect of an euro exit is no longer so far-fetched. The once unmentionable is now openly discussed by officials.

According to Guntram Wolff, deputy director of Brussels-based Bruegel think-tank, which published the Blue Bond proposal outlining a possible structure for common debt issuance:

If there are losses on these claims that the ECB has, these losses get distributed in the euro area as a whole, according to (national central banks’) capital shares at the ECB.

So in that sense it’s a euro bond but a special euro bond which … takes on a risk and distributes this risk in the entire euro system.

Chancellor Angela Merkel, who faces elections next year, showed no sign of dropping her objections to a common bond at a summit of European Union leaders last week, but new French President Francois Hollande is an advocate.

Berlin opposes the concept for fear it will end up paying for overspending in peripheries.

Hans-Werner Sinn head of Germany’s Ifo economic institute summed up the sentiment. He told Reuters that common bonds were the “logical consequence” of the TARGET2 system, but described this as “an inevitable force that pulls Europe into what I would call a disaster”.

If a Greek euro exit materialises, an outcome that hinges in part on elections next month, contagion will spread and emergency crisis action of some sort will be needed. Many analysts see common bonds as the best way of solving the crisis.

De Groot concludes:

(The TARGET2 system) is certainly something that they will have to bear in mind when looking at the consequences of any breakdown in the system. The bigger the claims versus liabilities grow, the bigger the chances that they will try to stop such a scenario of a break-down. This puts pressure on the Germans at some point to accept euro bonds.

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