Safe financing, but no safe asset yet

Measures to tame Covid-19 and save lives, brought sudden-stop to key sectors and the deepest global peace-time recession on record. Preventing recession from morphing into depression requires determined policy action; both to protect the supply side economy and to relaunch the demand side. Estimates vary, but for the euro area alone, the tally is set to run into trillions of euros, even in a favourable medical scenario. Access to stable financing is a prerequisite to policy action, and in Europe, new and unprecedented measures go a long way to securing this. Over the coming years, moreover, debt outstanding issued by the European institutions could exceed &euro;1.4tn, marking a sizable jump up from around &euro;360bn today. While European policy action has been critical to securing stable financing for member state governments, we find that new European bond supply would still fall short of delivering the genuine safe asset that the region needs. Lessons from the euro area debt crisis paved the way for quick action Before moving to the present day, recall that the euro area debt crisis of 2011/12 brought several quantum leaps on European integration aimed at breaking the national sovereign bank doom-loops at the heart of that crisis. The creation of the European Stability Mechanism (ESM), supported by the ECB&rsquo;s Outright Monetary Transactions (OMT), delivered a framework for assistance to sovereigns encountering financing problems. The Banking Union, albeit today still incomplete, delivered a pathway to strengthen the banking system and allow orderly bank resolution, without overburdening taxpayers. Although the Covid-19 crisis is of an entirely different nature, the new tools and lessons learnt from the euro area debt crisis nonetheless proved very useful. Early on in the Covid-19 crisis, European leaders agreed flexibility on the common budget rules and allowed exemptions from state aid rules, letting national government assist hard hit sectors with public loan guarantees and other supportive measures. The ECB was also quick to act with a new Pandemic Emergency Purchase Programme (PEPP) and ample liquidity support. With the framework of Banking Union, the authorities further offered coordinated regulatory relief to ensure that the banking system could keep much needed credit flowing. Early Spring, furthermore, saw a set of measures agreed, allowing euro area member states to draw on pandemic crisis support of up to 2% of GDP each (or almost &euro;240bn in aggregate), and, delivering European Union (EU) member states a temporary Support to mitigate Unemployment Risk in an Emergency (SURE) of up to &euro;100bn and EIB loans for firms, and notably SMEs, of up to &euro;200bn. A new quantum leap with the Recovery and Resilience Facility Even back then it was apparent that tackling the fallout from the Covid-19 crisis and ensuring European cohesion would require a facility that not only provided member states access to loans, but also allowed for some level of grants. Reaching agreement on such a facility proved a thornier process, but the 17-21 July Council delivered agreement and 10 November saw political compromise reached with the European Parliament, paving the way for ratification by the member states of the &euro;750bn recovery package, including the Recovery and Resilience Facility (RRF), with &euro;312.5bn in grants and &euro;360bn in loans, and a focus on green and digital transitions. The politically important point is that this marks the first time that the EU is allowed to borrow on such a scale to finance budget expenditures. And although the RRF is intended to be temporary only, consensus is that now that a framework has been established, it could be pulled out and used again in eventual future crises. Just how successful the RRF will be in securing economic recovery remains a topic of debate, with the potentially slow speed of roll out being one of the main criticisms. Important as this question is, our focus here is rather to consider whether the measures taken secure stable financing for national governments to fund the national measures critical for recovery and, with the increased issuance by European institutions, deliver a genuine safe asset for the region. Safe financing secured for national government A quick look at the major European bond markets tells the story of an initial spike up in peripheral bond yields as the crisis first struck and a subsequent decline, facilitated by the confidence afforded by measures taken both by the ECB and at the European level of government. Just zooming in on Italy, the 10-year benchmark yield is presently trading at a historic low of 0.7%, down from a peak of just over 2.40% in March. Albeit still trading at a 120bp premium over Germany, this marks a sharp contrast from the conditions that prevailed during the euro area debt crisis and pushed Italy deeper into recession. Rating agencies, moreover, also appear reassured by these developments, not least given that current bond yields allow the crisis measures to be financed at yield levels below the long-term trend potential, all else being equal, easing debt snowball effects. This is not to say that new risks and subsequent market tensions could not appear further down the road, but with the considerable support in place it seems unlikely that the Covid-19 crisis would be a direct trigger. For that to happen, we would need to see Europe roll back on its policy promises, and not least on the ECB&rsquo;s PEPP. Genuine safe asset still a distant prospect The change of heart in the traditionally frugal member states to allow a flurry of measures that, if drawn in full, could see the combined debt of the European Commission and ESM/EFSF exceed &euro;1.4tn from the present outstanding of around, respectively, &euro;50bn and &euro;310bn, has furthermore generated some excitement that this could mark the emergence of a genuine safe asset for Europe. Note, some authors also include EIB issuance, but we see this as distinct although the EIB is an equally high-quality issuer. While the headline size of &euro;1.4tn (or 11.7% and 10.0%, respectively, of euro area and EU27 GDP in 2019) is certainly impressive, we see several reasons why this new issuance potential from the EU and ESM is still a long way from the genuine single safe asset that Europe needs. While both the EU and ESM are triple A issuers, the idea of a genuine safe asset stretches well beyond credit risk and requires a number of technical considerations to ensure a deep and liquid market across the full yield curve. A further point is to ensure that the safe asset &ldquo;do no harm&rdquo; to national government bond markets. Kicking off with some of the more technical considerations, we note first that with funding conditions in national bond markets much improved, take up on the European programs could be limited primarily to the &euro;312.5bn of grants, considerably reducing the size of potential issuance. Even if the full &euro;1.4tn is reached, this would be a maximum from which the aim would be to shrink in size. There is furthermore a lack of steady supply, with EU issuance being temporary and ESM issuance driven by financial assistance needs. Finally, we note fragmentation in debt issuance by institution and, potentially also, by issue types.. These issues could at least in part be overcome by pooled debt management and a political agreement to maintain a minimum outstanding volume. The deeper issue to our minds, however, is what such an instrument could entail for national bond markets. As already noted above, the immediate effect of the combined measures of the EU and ECB listed above have clearly been positive for peripheral bonds, by boosting confidence in the ability of Europe to work jointly to resolve crisis and ensure safe financing for national governments, and thus better economic outcomes for the entire region. If the EU/ESM issuance were to be given preferential treatment over national bond markets, be it on bank balance sheets, balance sheets of regulated investors, such as pension funds, or in ECB operations, then this could work to the contrary, and increase the risk premia on peripheral debt. This would in turn increase the risks of new sovereign debt stress, at a potentially very significant economic cost to the entire region. Ensuring that national government maintain access to safe financing, at least for the share of their financing needs that fall within the limits set by the European fiscal rules, must be a prerequisite to building a safe asset. There is both an economic and political argument behind this view. On the economics, consider a crisis that triggers flight to safety and causes a large member state on the periphery to lose market access for its government bonds. Under the present arrangements, set out in the ESM Treaty, the debt of the member states in question would then be assessed and, if deemed unsustainable, restructured with Private Sector Involvement (PSI). While some may consider the risk small, the mere reality that a PSI decision on a large member state could trigger a deep financial crisis for the euro area, with global spill over, should render it unacceptable. Conversely, merely asking the other member states to commit additional funds for financial assistance may be deemed politically unacceptable. Balancing these economic and political constraints sits at the heart of the many proposals set out for the creation of a euro area safe asset, be it Red-Blue Bonds, Purple Bonds, Sovereign Backed Bond Securities (SBBS) or E-bonds. Returning to the European response to the Covid-19 crisis, while very different in nature to the euro area debt crisis, it has clearly drawn important lessons from that experiences and not least when it comes to safe financing for governments, which this time round was clearly given priority. This experience can now be built upon to deepen integration with more common fiscal tools and thus build an increasingly sound basis for a genuine safe asset, which would help secure the finalisation of Banking Union, the build out of Capital Markets Union and a greater international role for the euro. Once again, Europe integration is showing its value in crisis.

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Safe financing, but no safe asset yet

While European policy action has been critical to securing stable financing for member state governments, we find that new European bond supply would still fall short of delivering the genuine safe asset that the region needs.

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