The earliest example of supranational borrowing in Europe dates back to the 1975 Community Loan Mechanism, which was then setup in order to respond to the negative effects of the first oil shock on member states’ balance of payments. The Commission was at the time empowered to issue bonds backed by the Community budget and national guarantees, borrowing funds and lending them on to struggling countries. The logic of using the Community’s favourable credit rating to provide cost-effective loans to member states thus set an important precedent. Since the 1990’s, with the several steps of the creation of the European Monetary Union, the debate focused on the potential distortions in the newly formed euro area public debt market and several advocates had already suggested the creation of an EMU Fund that would borrow money from capital markets, completely replacing national issuance, and lend at a differentiated rate calculated on each country’s fiscal standing. The aim would have been to rectify the inability of financial markets to distinguish between ‘virtuous’ and ‘lax’ member states, which had led to a broad yield convergence, following the adoption of the euro. The mechanism would also have raised borrowing costs for ‘reckless’ member states, incentivising budgetary discipline. The debate on debt mutualisation rose once again with the Euro area sovereign debt crisis which sparked doubts on the unity and viability of the single currency. In the early years of crisis, proposals mainly sought to address widening spreads and increasing borrowing costs. With the progression of the crisis, however, academics and policymakers alike increasingly sought to address two key concerns: 1) skyrocketing borrowing costs threatening countries to lose their access to capital, and 2) unsustainable public debt levels in the Eurozone. The majority of the instruments proposed the creation of a treasury-like debt agency aimed both at pooling a share of existing national debt, and at issuing debt jointly guaranteed by the participating member states. In spite of many similar proposals towards some form of “EU-bonds” creation, the actual European response to the crisis fell short of establishing any treasury-like permanent institution for the euro. First, in May 2010, the Commission created the European Financial Stability Mechanism (EFSM), with a maximum capacity of €60 billion. Second, ECOFIN established the European Financial Stability Facility (EFSF), raising funds up to €440 billion thanks to the guarantees of its stakeholders, i.e. Eurozone governments. Third, the European Stability Mechanism (ESM) was established as an intergovernmental financial institution outside the treaty framework, with a maximum lending capacity of €500 billion and replacing the EFSF as a permanent institution. Rather than pooling any past or future debt, all these mechanisms were built on the logic of mutualisation of borrowing costs, providing emergency credit access to struggling economies. With the exception of the ESM, the facilities were of temporary nature, and none of them provided a permanent stabilisation mechanism, opting instead for a recourse of last resort.
While the recent years were marked by an almost dead point with regards to discussions on further permanent financial integration within the European Union, the Covid-19 pandemic reignited debates on the need for debt mutualisation and joint issuance in the European Union. Following the April 2020 Eurogroup meeting, the initial response resorted to existing mechanisms with 1) the activation of an ad-hoc Pandemic Crisis Support ESM facility, and 2) the Commission’s SURE, a temporary mechanism to support national short-time work compensation schemes. However, numerous critics pointed to the inadequacy of these instruments alone and stated the need to introduce a temporary mechanism to mutualise the costs of the crisis through either a one-off joint or supranational bond issuance. The urgent character of the crisis also prompted the choice for integrating the response into the ongoing negotiations for the Union’s 2021-2027 Multiannual Financial Framework (MFF). While earlier proposals called for Member States’ guarantees (either joint or not), the idea to utilise the EU budget both as a guarantee and the vehicle for repayment progressively became the dominant approach (as highlighted notably in the Franco-German proposal of 2020). Furthermore, the logic of cheap loans, which had been dominant during the euro area sovereign debt crisis, came to be less relevant due to the symmetric nature of the crisis, the absence of moral hazard, and the burden it would represent on the already fragile fiscal position of several countries. The focus was directed towards a grant-based approach instead, where the repayment of principal and interest would be spread over a long period of time and based on a reimbursement key considering parameters such as population or GDP. In this context, on 27 May 2020, the European Commission proposed the creation of a €750 billion instrument called Next Generation EU (NextGen EU), to support recovery efforts. Besides the financial magnitude of the program, the key innovations of the recovery instrument lie both in its intrinsic mechanism and in its repayment logic. In order to be able to repay the funds raised on financial markets, the Own Resources Decision – a legal instrument that determines how much money the EU is permitted to spend – added a temporary increase in the expenses, worth a further 0.60% of the European Union’s Gross National Income (GNI) which, as per legal text, “should expire when all funds borrowed have been repaid and all contingent liabilities relating to loans have ceased, which should be by 31 December 2058 at the latest”. This particular characteristic had been challenged notably by Germany’s Federal Constitutional Court before being later confirmed by the European Court of Justice. On 31 May 2021, the Own Resources Decision was ratified by all Member States in line with their constitutional requirements, allowing the Commission to finance the recovery. Following that decision, on 15 June 2021, the first NextGenEU transaction raised €20 billion via a bond issuance. As this timeline shows, in a record amount of time, the European Union’s institutions have created, voted and issued their first mutual debt when placed in front of the adversity of the Covid-19 pandemic. Even though the talks had always been ongoing and numerous ideas had been raised, they had always been cut short and only the extreme shock of the crisis and the urgent recovery funding needs it created, allowed the political response to live up to its expectations. The “whatever it takes” narrative previously declared by Mario Dragui in 2012 in the light of the debt crisis, as well as the traumas left by the last economic turmoils combined to a somewhat “constrained” response offered by the European Central Bank both allowed the monetary union to reshuffle the dynamic and overcome its numerous political opponents.
In May 2020, more than 40 million people in Europe had part of their salary paid by EU Member States. It thus comes with little surprise that the first form of recovery programme that was launched at the early stages of the Covid-19 pandemic is the Support to mitigate Unemployment Risks in an Emergency (SURE) fund. Aimed at alleviating the countries’ debt burden caused by unemployment, the program is entirely financed through Social Bonds issued on the debt capital market. SURE is a temporary instrument which offers financial assistance of up to €100 billion in the form of loans granted on favourable terms to Member States experiencing a sudden and severe increase in public expenditure for the preservation of employment and healthcare services. All Member States are eligible, however financial assistance offered by SURE is based on voluntary requests from countries affected by the Covid-19 crisis in terms of employment and healthcare. It is backed by a system of voluntary guarantees from the EU’s national governments worth €25 billion. Each Member State’s contribution to the overall amount of the guarantee corresponds to its relative share in the total gross national income (GNI) of the European Union, based on the 2020 EU budget. The program is attractive for countries with weak fiscal positions for which SURE loans are likely to be cheaper than their own borrowing costs, even though it has relatively shorter durations. In fact, terms on which the European Commission borrows are directly passed to the Member States receiving the loans (back-to-back loans). While the amount of loans granted is decided by the European Council, based on proposals from the European Commission and considering the needs of the requesting State, the existence of the exceptional circumstances that caused the economic disruption in the Member State are assessed every six months (as SURE is meant to be only a temporary instrument). With the latest disbursement to date on 25 May 2021, the European Union had provided nearly €90 billion in back-to-back loans. All of the 19 Member States which had asked to benefit from the scheme have received part or all of the requested amount. Other Member States can still submit requests to receive financial support under SURE up until the overall firepower of €100 billion is reached. The funds have been disbursed through a total of 7 issuances, across various bond maturities. The bonds are issued as social bonds and follow a Social Bond Framework meant to provide investors with confidence that the funds mobilised will serve a truly social objective.The Commission reports to the European Parliament and the European Council provide detailed calculations of the interest rate savings realised by Member States which benefited from the SURE program, calculated by computing the average spread at which the funds were disbursed under the SURE program compared to the average yields on existing national bonds. As mentioned in the report: “These savings were generated as SURE loans offered Member States lower interest rates than those they would have paid if they had issued sovereign debt themselves. This is due to the EU’s AAA credit rating and the liquidity of the bonds.”
It can easily be observed that the countries who have requested additional support from the programme are Member States whose credit quality is considered to be weaker than some of their European counterparts which did not apply to the program (such as France and Germany for example). Thus, as per the above table, all States (at the exception of Estonia, due to calculation limitations) have benefitted to a certain extent of interest savings by using this mechanism instead of borrowing funds on their own. However, we can also notice the discrepancies between the countries, highlighting the fact that the benefits are not equally spread amongst Member States which despite being an expected statement can be seen as striking in terms of amounts. Some of the discrepancies can be explained by the fact that certain countries issue fewer national obligations which ultimately causes their borrowing rates to be higher because of liquidity and investor demand. However, we notice that even countries which issue a consequent amount of national sovereign bonds (such as Italy for example) manage to gain a substantial amount of savings compared to their regular issuances. While the SURE program is a temporary program decorrelated from the Next Generation EU-Recovery Plan, it could be seen as a form of trial run for the NextGen mechanisms. Analogously, SURE bonds, which deeply transformed the EU’s capital market profile, were the premise of the NextGen issuances, as stated by Gert-Jan Koopman1 during a conference in March 2021: “The first SURE issue in October was the largest social bond ever issued and marked the transition of the EU from being a small player in the capital market to a serious SSA2 issuer”.
NextGen EU is a temporary recovery instrument resembling in many ways the SURE programme, despite being implemented on a much larger scale. The aim of the programme is to help repair the immediate economic and social damage brought by the Covid-19 pandemic as well as ensure green, digital and sustainable growth for the future. While the SURE program was intended to be a temporary program linked to a specific situation and time frame, the NextGen goes beyond that by defining a framework that is suitable for longer-term objectives and implementation. The centrepiece of the programme is the Recovery and Resilience Facility - an instrument to offer grants and loans which will then support reforms and investments in the EU Member States with a total value of approximately €807 billion (in current prices). Part of the funds – up to €338 billion – will be provided in the form of grants, which are handed out free of compensation and repaid using the EU budget. The programme will also include an €83 billion contribution to several existing targeted programmes such as the REACT-EU programme or Rural Development Fund for example. The other part – up to €386 billion – will provide Union loans to individual Member States. These loans will be repaid by those Member States, even though they are ultimately guaranteed by the EU budget. The funds under the Recovery and Resilience Facility will be distributed according to national plans prepared by each Member State, in cooperation with the European Commission, and in line with an agreed allocation key. As of January 2022, all 27 states except the Netherlands had submitted their plans for review. To finance the NextGen programme, the EU will borrow directly on the markets using debt spread across several maturities (up to 30 years) with the latest payment being due in 2058, as the programme will be ongoing for 7 years starting in 2021. This will avoid immediate pressure on Member States’ national finances and enable EU countries to focus their efforts on the recovery. Bonds will be issued both via syndicated transactions and via auctions. In addition to issuing new bonds with new maturities the Commission is also augmenting the amount of already issued bonds (taps). By doing so, the outstanding amount of the bond is increasing, making these bonds more liquid in secondary market trading and hence more attractive to investors. In addition, the Commission will seek to raise 30% of the funds through the issuance of NextGenerationEUgreen bonds and use the proceeds to finance green policies. This allows the institution to tap into further pockets of liquidity following the surge in demand for ESG products in recent years, especially by institutional investors such as insurance companies and asset managers. The main differentiator of this programme is that, in order to back the borrowing, the EU will use the budgetary headroom (i.e. the difference between the Own Resources ceiling of the long-term budget and the actual spending3). To that end, the headroom has been increased by an additional 0.6% until 2058, to guarantee the Union can always rely on EU budget funding to repay and will keep its high credit rating in order to continue and borrow funds under advantageous financial terms. The responsibility of individual member states is ultimately capped, so the member countries are not individually liable for the entire borrowing of the EU. The additional annual responsibility of an individual member state, on top of its relative share, is thus capped at 0.6% of the member state’s GNI (for example around EUR 21bn in the case of Germany).
The first intuitive representation to outline the structure of the model is to graph the term structure of the most important European countries, GDP-wise, and compare it – visually – to the term structure of the EU issuances.
We notice that the EU issuance curve is in the median range compared with the other four countries on the short-end part of the curve (1m-10y). If we look at the 10-year yield, which is the most natural benchmark point, we note that the EU curve has the lowest yield after Germany, considered as the most safe haven asset. This is also observed for the highest maturities of the curve up to 30 years, which is the last comparison point as the longest NextGen bond matures in 2051. A first simplistic read of this curve shows us that all the major countries except Germany should benefit from lower yields using the EU mechanisms than raising debt via their own respective treasuries. The main limit to this simplistic comparison is that the EU bonds are not guaranteed by a single sovereign State, they are in fact guaranteed by the European Union budget which allows the guarantee, and ultimately the risk priced in the bonds, to be in fact “distributed” amongst those of the Member States. As highlighted on the European Commission’s official channels: “In the unlikely event of non-payment of a loan beneficiary, the EU budget guarantees that the EU timely honours its obligations”. This is a (if not the most) crucial factor, especially considering the discrepancies existing in between the different countries constituting the Union. By way of illustration, the below table highlights the current sovereign ratings of the Euro area. By way of comparison, as of now the European Union is rated AAA/Aaa (outlook stable) by Fitch and Moody’s and AA (outlook positive) by Standard & Poor’s.
As we can observe, ratings can widely differ from one country to another, ranging from the highest grade for Germany and the Netherlands to the lowest grade of the region for Greece, which is the only country to be classified as high yield across all three ratings agencies. However, the mechanism created by the Union allows the newly issued bonds to benefit from a common rating, thus ultimately creating a “best-off” basket as the countries which are the most poorly rated will benefit from the guarantees offered by the higher ratings of their counterparts (and one could argue the opposite for the highest-graded countries). That constatation being made, we had to find a denominator that would allow us to represent in the most efficient way the different countries of the Union and their respective economic “weights”. Our working hypothesis has thus been to use the ECB’s capital key to be able to represent each sovereign economy according to the weight it carries within the Union. This indicator is also widely used in the SSA space (ex:. ESM). The capital of the ECB comes from the national central banks (NCBs) of all EU Member States and the NCBs’ shares in this capital are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU with the two determinants having equal weighting. The shares are adjusted by the ECB every five years as well as whenever there is a change in the number of NCBs that contribute to the ECB’s capital. The latest adjustment took place in February 2020 following the withdrawal of the United Kingdom from the EU. For each of the paid-up subscriptions of euro NCBs to the capital of the ECB, we have used the capital key to calculate a “weighted average EUR benchmark yield”. To that aim we have made the following assumptions:
For convenience, we have excluded all countries not in the eurozone (approximately 20% of the weights).
We have accordingly re-calibrated the weights to sum up to a 100% basis. Practically, each country’s capital key has been multiplied by 1/(sum of euro-zone keys). The unadjusted and adjusted weights are highlighted in the below table.
This calculation allows us to calculate a theoretical EU average yield, which is the effective yield at which each underlying country is borrowing at multiplied by the weight given by the computed capital key. The final aim will be to compare that yield with the effective yield the NGEU bonds are pricing at and thus be able to conclude on how the market prices these mutual issuances. It is worth noting we have limited our modelling to NGEU bonds and excluded the SURE issuances which do not include some of the “major” countries, essential to the underlying analysis. In order to easily implement this model and in the interest of making it accessible and reproducible to potential readers, we have used the widely-used professional Bloomberg terminal and, amongst others, its CIX (Custom Index Library) function. This function allows us to gather each countries’ yields and their corresponding weight to compute the below formula:
To effectively calculate our custom index, we need to make a maturity assumption on the yield, such as, in that particular example:
Yield = Yield on 10y tenor
For each country represented in the model, we will use the 10-year maturing bond marked as the “generic” 10-year benchmark for that specific country. It is worth noting that the model is thus reproducible with any benchmarked maturity as long as it is available for all its underlying components. The output graph comparing the historical yields of the 10-year benchmarked index (white) to the NextGen EU curve (red) for that same maturity is shown below. We can extrapolate the comparison and add to the graphical representation the four key Eurozone 10-year yields, respectively France (purple curve), Germany (yellow), Italy (orange) and Spain (blue).
We observe that the computed curve’s yield is significantly higher than the one from the issued NextGen bond, thus formally confirming the fact that the EU-issued bond benefits from better funding than the simple “sum” of its components. The spread between these two yields effectively gives us a sense of the credit worthiness of the multiple protection layers of the European Union “block” and effectively shows us the competitive advantage of the EU as a borrower on the markets compared with each standalone country. We can also see that the spread between the two yields has significantly tightened with the anticipation of QE ending. This is largely due to quantitative easing policies led by the ECB ultimately encouraging European emissions as the mandate to buy SSA is higher in percentage than the one to buy EGB bonds. One of the other advantages offered by the NextGen issuances is the creation and installation of a deeper and more liquid SSA market. As of 2021, the EU had already begun the largest issuer of euro-denominated bonds in the primary SSA market showing its preponderance in that space. If EU bonds are still far from representing a threat to EBG markets, some pockets are more affected than others by the arrival of these new forms of bonds. So far, the observed demand for the NGEU bonds has been at record-high levels, with the largest chunk of investors being domiciled in the euro-zone. In a research paper, UniCredit highlighted the fact that, even though EU bonds did not represent a direct threat to safe-haven assets such as German bonds, “EU bonds are likely to be particularly attractive relative to mid-size issuers, such as Austria and Finland. Their liquidity is likely to be comparable, their ratings higher, and EU bonds are currently trading with higher yields”.
While the pandemic has propped up national debts to record highs, the effects and market reaction created by such issuances could pave the way for more sustainable state funding solutions. The question is even more critical in an economy led and kept afloat by exceptionally lenient central banks, a situation which is by essence not meant to last eternally. While the prospect of rising interest rates could endanger most of the world’s largest economies in an already fragile situation, joint debt issuance, and further on debt mutualisation, could provide new solutions to keep countries afloat and could be the catalyst to answer the new needs for funding created by societal and environmental concerns. Ultimately, the question will be whether when the current environment changes, any of the mechanisms will survive in the long-run. While NGEU is still considered a temporary instrument for the time being, one could wonder if the mutual debt issuances could not become a more permanent solution. Extraordinary circumstances have led to the current situation but the evolution is still fragile and largely dependent on the ethos the European Union will want to give to its alliance. n
