With countries gradually reopening from COVID-19 lockdowns, governments’ focus seems to be shifting from what measures they should take to curtail the virus’s spread to how to respond to the economic impact of said measures. In the eurozone, some have proposed a long-debated measure as a potential solution: pooled sovereign debt (also known as collectivising or mutualising it)—a concept we will explain in further detail below. Most recently, Germany—long against the notion of sharing debt with other eurozone countries—and France announced they would bless the issuance of €500 billion in joint EU debt to help member-states fund their coronavirus responses. Whilst it is uncertain if the European Commission (EC) and all other member-states will agree to such a proposal, we think investors would benefit from understanding the debate over this long-running political issue—and seeing why it isn’t likely to go away regardless of how the current situation plays out.
Whilst coronabonds—as many call hypothetical joint EU debt to fund coronavirus responses—are a new talking point, the concept of eurozone nations pooling debt isn’t. When the euro debuted in 1999, the creation was as much a political project as an economic one. But creating this required compromises. One such bargain: Whilst politicians agreed to share a currency, they didn’t agree to share tax revenue, expenditures or debt at a federal level. However, most places that share a currency also have a fiscal transfer union, meaning their debt, federal tax revenue and expenses are collectivised. In other words, the eurozone would issue debt and collect taxes as a single entity, then spend across member-states. That allows economically strong areas to effectively subsidise weaker ones. Since the eurozone doesn’t pool debt, each member-nation sells its own to fund budgets, which it pays interest on.
But investors’ perception of these nations’ creditworthiness varies widely, as do interest costs. For instance, Germany, which has relatively low debt at 60% of gross domestic product (GDP, a government-produced measure of economic output), a budget surplus and strict spending rules, had 10-year government debt yields of -0.57% on 30 April.[i] The same day, Italy—with a 135% debt-to-GDP ratio—had to pay 1.79%.[ii] Those who back collectivising eurozone debt argue that if one nation struggled to borrow, it could face tough decisions about whether to default or exit the euro and repay debt in a devalued local currency.
This is exactly the debate we saw amongst politicians and commentators during the 2010–2012 European debt crisis. Then, Greece and Portugal had to take bailouts—and we saw many analysts fearing Spain and Italy were on the verge. The debate recurred in 2015, amidst continued worries over Greek and Cypriot debt. Financial commentators we follow warned the euro would splinter if these nations defaulted and left the common currency. The solution championed by some eurozone leaders was to pool debt in eurobonds. The trouble is, many voters in more fiscally stalwart nations—including Germany, Austria and the Netherlands—argued they shouldn’t have to pay for poorer countries they see as fiscally irresponsible. They further argued sharing debt may encourage even bigger deficits and debts ahead.
Now, the debate is back. The European Commission currently expects eurozone GDP to fall -7.5% in 2020 tied to coronavirus lockdowns, with Spain and Italy particularly hard hit.[iii] EC President Ursula von der Leyen has estimated the eurozone will need €1 trillion to help pay for economic rescue packages aimed at mitigating joblessness’s pain, increasing healthcare spending and otherwise helping cushion the sharp blow.[iv] The EC estimates, between rising debt and decreasing output, Spain and Italy’s debt-to-GDP will jump to 122% and 161%, respectively. Hence, on 25 March, the leaders of nine countries including Italy and Spain sent a letter to von der Leyen, stating the eurozone needed to issue coronabonds to raise crisis-response funds. They argue more highly indebted nations can’t afford the coronavirus response without them.
However, in our view, coronabonds aren’t really as necessary as some say—even for countries, like Italy and Spain, that are likely to suffer most from the current crisis. Whilst many financial commentators warn against adding to Spain and Italy’s high debt-to-GDP, these ratios alone don’t mean problems loom. Governments don’t use GDP, which is basically the amount of goods and services produced annually, to meet obligations. They use tax revenue. Hence, in our view, Italy and Spain’s ability to pay interest and principal due on their outstanding debt determines whether that debt is sustainable.
At last year’s end, Italy’s interest payments accounted for about 12.4% of tax revenues—a multi-decade low—whilst Spain’s interest payments accounted for 13.6% of tax revenues.[v] These figures are not far removed from the US’s debt-service costs, 10.8% of tax revenues in 2019.[vi] They are a far cry from the 1990s, when Italian interest payments accounted for about 40% of tax revenues and when Spain’s interest payments accounted for about 20% of tax revenues.[vii] Plus, with yields historically low, Italy and Spain’s debt piles aren’t likely a crisis-in-waiting, in our view.
Some might rationally argue that rising interest rates could make interest costs rise, rendering debt unaffordable. Whilst this is true in principle, we don’t view it as an immediate risk. Both nations primarily issue debt at fixed interest rates. Therefore, changes in interest rates affect the cost of newly issued debt only. Presently, Spain’s average debt maturity is eight years, whilst Italy’s is seven.[viii] Therefore, we think sovereign yields would have to rise much higher—and stay there for years—for trouble to arise. In the meantime, with long-term sovereign yields near the low end of their historical range, both nations are able to refinance maturing debt at cheaper rates. On 29 April 2010, Italy’s Treasury sold 10-year debt at a 4.00% interest rate.[ix] The Treasury effectively refinanced those fixed interest securities at an early April auction of new 10-year notes. The interest rate? A far lower 1.35%.[x] Similarly, on 20 May 2010, Spain’s Treasury sold 10-year debt at an average 4.1% yield.[xi] With 10-year debt presently trading at 0.82%, the likelihood Spain refinances the maturing debt at a cheaper rate than 10 years ago appears quite high to us.[xii]
Additionally, in our view, the likelihood of long-term interest rates spiking is low. Our analysis shows interest rates tend to move with inflation expectations, as investors will generally demand a higher interest payment in order to maintain purchasing power over time if they expect prices to rise. We think that scenario looks unlikely in the near future. Even after the spread between long and short rates widened since February’s end, it is still around its narrowest in about a decade.[xiii] Our research shows this weighs on bank lending, as banks generally secure funding at short-term interest rates and lend at long-term rates, with the difference between the two the basis for their profit margins. When the spread is narrow, the potential profits on new loans diminish, which we think discourages new lending. Because most components of broad money supply stem from lending, weak loan growth can diminish money supply growth, which economic theory holds is the primary inflation input. So long as these conditions hold, we would anticipate inflation remaining tame.
We aren’t taking any sides in the debate over whether to pool eurozone debt or not. But whether or not France and Germany succeed in doing so, it doesn’t seem immediately necessary to us. This is because even the more indebted nations still appear capable of servicing debt without assistance—particularly with the European Central Bank still purchasing long-term sovereign debt, which keeps a buyer of last resort in the marketplace. In some ways, this looks mostly like an extension of the long-running debate over how to “complete” the eurozone by further intertwining nations’ finances via a fiscal transfer union. However the specific debate over coronavirus bonds ends, we fully expect this debate to recur whenever the next eurozone recession comes to pass.
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[i] Source: FactSet, as of 12/05/2020.
[iii] “EU Facing ‘Deep and Uneven Recession’,” Andrew Walker, BBC, 06/05/2020.
[iv] “The EU Should Issue Perpetual Bonds to Fund the Economic Recovery From Coronavirus,” George Soros, Project Syndicate, 23/04/2020.
[v] Source: FactSet, as of 06/05/2020.
[vi] Source: St. Louis Federal Reserve, as of 18/05/2020.
[vii] Source: FactSet, as of 18/05/2020.
[viii] Source: Tesoro Público de España and the Bank of Italy, as of 18/05/2020.
[ix] Source: Ministero dell’Economia e delle Finanze, as of 18/05/2020.
[xi] Source: Tesoro Público de España, as of 19/05/2020.
[xii] Source: FactSet, as of 19/05/2020.
[xiii] Source: FactSet, as of 18/05/2020.