Europe ups ante on eurobonds

@CNNMoneyInvest November 23, 2011: 11:39 AM ET
Eurobonds could help bring down rates in higher debt-ridden countries, but it would increase borrowing costs in other eurozone nations.

Eurobonds could help bring down rates in higher debt-ridden countries, but it would increase borrowing costs in other eurozone nations.

NEW YORK (CNNMoney) -- When it comes to ideas to solve to Europe's debt crisis, nothing seems to stick. And that's the case with the latest one.

On Wednesday, the European Commission unveiled a plan detailing three options for so-called eurobonds, which would effectively pool the debt of the 17 eurozone countries.

While the EC's paper is not a formal proposal, the commission said it has decided to launch a "broad consultation" to seek the views of relevant parties and the advice from other institutions.

Eurobonds are controversial. Experts still aren't convinced any of the ideas would work -- or ever garner enough political support to move forward.

The idea has been floating around for months, with little support from the stronger eurozone countries, like Germany.

German Chancellor Angela Merkel has maintained strong opposition to eurobonds, even calling them the "absolutely wrong" way to defuse the European debt crisis. She reiterated those sentiments Wednesday, and criticized the EC for focusing on the idea.

Still, EC President Jose Manuel Barroso is confident that the ideas may gain some traction.

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"The idea of having stability bonds is making its way," Barroso said Wednesday. "We are trying have a rational, reasonable, intellectual and politically serious debate. We believe this document does precisely that and encourage all parties to tell their opinions."

He dismissed Germany's opposition, and said its resistance is more related to timing than principles.

The first approach the EC is offering up is to convert all national government bond issues, including those currently outstanding, to a common eurobond that is backed by all 17 countries in the eurozone. The commission called the plan its most "ambitious."

"Economically, this is the most promising option," said Jürgen Odenius, international economist and investment strategist at Prudential Fixed Income. "But political interests aren't lined up in support of this proposal."

While that would drive down borrowing costs for debt-laden countries such as Greece, Italy, Portugal, Ireland and Spain, where yields are soaring, it would also boost rates in Germany and Europe's other AAA-rated countries, where rates are significantly lower.

Because the credit risk would be spread across the eurozone, countries like Germany, which boasts a lean gross debt level of just 80% of its economy, would be taking on the debt loads of Greece, which totals more than 160% of its economy, and Italy, which runs a debt-to-GDP ratio of 120%.

Europe's healthier nations are "unwilling to engage in such a venture because they become liable" for the debt service payments of entire regions, including Greece and Italy, without having a say in their future fiscal actions and policies, said Odenius.

"It's like taxation without representation," he added.

Without Germany's support, this optimal approach to the eurobond could not be implemented.

But beyond needing Germany's support, it would also require changes in the European Union's treaties. Those changes would need to be ratified by each of the 27 member states, and that process would likely take years, experts said.

The EC also recognized that some of its options would require legal changes. But the commission added that "regardless of any necessary time for implementation, agreement on common issuance could have an immediate impact on market expectations and thereby lower average and marginal funding costs" for eurozone countries under pressure.

The EC's second approach would also require a change in EU treaties, making it another unlikely option.

Under scenario No. 2, eurozone countries would be allowed to issue common eurobonds up to a certain limit, such as 60%, of their annual GDP. Beyond that level, individual governments would be responsible for issuing and backing their own bonds.

Because this plan would also require fiscally responsible countries like Germany to be liable for a portion of other countries' debt, it would most likely be met with the same resistance as the pure eurobond plan.

Plus, this type of structure doesn't address Europe's structural debt problems over the longer term.

Prudential's Odenius added that this option would also result in a massive sell-off in the portion of existing debt that wouldn't get converted into a eurobond, therefore potentially wreaking havoc on bondholders, including Italian banks and other financial institutions.

Finally, while the EC's third suggestion doesn't face a political brick wall, since it doesn't require changes in EU treaties, experts are wary about its overall effectiveness.

Europe: The crisis that just won't quit

This approach would have countries provide some guarantees on newly issued bonds, but it would not combine the liabilities or get rid of national bonds.

This approach is most similar to the bonds that are currently issued by the eurozone's €440 billion European Financial Stability Facility, but the difference is that eurobonds would be available even outside of a crisis scenario.

Already the credit worthiness of the EFSF 10-year bonds is deteriorating, as the yield spread rapidly widens over German bonds. Last month, the spread was around 55 basis points, and now, it stands around 200 basis points, said Odenius.

"The credit of this type of eurobond will only be as worthy as the average euro area, and if a large part of the region is suffering liquidity problems, these instruments will have a limited effectiveness," said Odenius.

So European officials can continue to theorize options to stave off a worsening debt crisis and contagion, but experts say investors are impatiently waiting for one single solution: intervention from the European Central Bank as the lender of last resort.

"The ECB will eventually be drawn into this crisis in earnest, and it will have to provide a full, unlimited commitment to act as a backstop to the countries experiencing a liquidity crisis," said Odenius. "These efforts would need to be paralleled by an International Monetary Fund program with comprehensive conditionality. This process could be facilitated through ECB loans to the IMF."

Without that, the eurozone could be forced to bear a breakup, but experts don't expect it to come to that. To top of page

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