Bonds, Bonds and…Eurobonds!

Cash is liquid. Lack of cash is a lack of liquidity. Hence, the PIIGS (or at least, Greece, Ireland and Portugal so far) have this problem. They’re tackling it with massive austerity programmes to try bring government revenue (taxes) to balance with expenditure (health, education, transport etc). Austerity takes time.

A key question that comes up is: What are bonds? The real question should be: how do governments borrow? How do they pay for deficits? Right now, each EZ member issues its own debt (in the form of bonds) to pay for deficits in their national accounts.

Each eurozone (EZ) member issues debt in the form of bonds. A bond isn’t a physical thing. Its an IOU. You can think of it as an embossed piece of paper with the amount borrowed written on it if you’d like with an interest rate attached i.e. ‘I, Ireland, promise to pay you €1m in 20 years at 4% interest.’

The government gets the money to use now and agrees to pay it later. It is for this reason that bonds are called ‘Treasury Bills’ or ‘Gilt-edged Securities’ because they go to pay for the running of the country and a country is hardly likely to go bankrupt like a business can.

‘The Market’

Lets use Ireland as an example. Ireland uses the euro and needs cash. Ireland issues debt in the form of a bond. What this means is that Ireland asks investors (usually banks at home and abroad) to borrow money at a certain interest rate. Like any loan, the higher the risk, the higher the bank will charge you per year in interest. At the end of a stated period (could be 2 years or 100) the investor/banks get paid the face value of the bond back. The interest is the profit on the deal.

Suppose an investor begin to reckon that his Irish bonds aren’t a great investment after all?

This could be because:

  1. Theres high inflation in Ireland and the value of the original bond is declining
  2. Theres a risk Ireland wont pay the bond (default)

You’ve probably guessed (2) is the problematic one today in the PIIGS. Investors are even faced with a slightly different version of ‘default’ called ‘debt restructuring’ which usually means investors receive a ‘haircut’ i.e. lose a high % of the initial value written on the bond.

An Investor thinks he might get stiffed. What does he do?

The bond (embossed paper remember!) doesn’t just sit in the investors drawer. He trades it with other investors on bond markets.  If he thinks that suddenly the Irish bonds he owns are going to lose their value (or not be paid up), he’ll sell it!

Well, he charges a higher rate of interest. This makes it very expensive for Country A to borrow. Country A has a problem. It must borrow to pay for its mounting deficits or else it wont be able to pay any of its debts and default.

What if he still holds Irish bonds? No matter. Bondholders get paid back before shareholders do.

 

So, whats the deal with Eurobonds?

As one recent image from The Economist illustrated well, ‘Eurobonds’ would be issued by the eurozone-17, not single member nations.

The reason why this would be a good thing is pretty straightforward. Imagine you buy your mother a sub-par present for her birthday and want to save face by combining that gift with your brothers much better one and put both your names on the collective birthday bundle. The good balances out the bad. Yin and yang, etc. Of course, the ‘good’ in this case are the six AAA rated eurozone nations and the bad are the PIIGS. Collectively, deficit/debt problems in the EZ look reasonable. For the EZ as a whole, the Debt : GDP ratio is 88% (higher on the periphery balanced by lower levels in the core.) This compares with a level of 98% for the US, 83% for the UK. Deficit levels in the EZ-17 are 4%, far better than the US level of 10% and 8.5% for the UK.

So, united, the EZ is stronger than its component parts. The EFSF, while a nice big chunk of change, is still not a comprehensive solution. If any of the AAA-rated EZ nations (France is the biggest worry) get downgraded, the €440bn EFSF wont be able to borrow enough water to quell the fires raging in the PIIGS (even without a downgrade, this is questionable.)

Why isn’t it being done?

To use the gift metaphor again. Imagine we were talking about prices. By pooling presents, you are effectively pooling the costs of them. So if you spend €10 and your brother €40, then it really looks like you spent €25 each. So you receive all the thanks and praise on a gift worth €25, rather than €40, meaning the net effect of pooling was -€15. In the EZ case, more creditworthy (and ‘wealthier’) countries such as Germany therefore will have to sacrifice their own low rates of borrowing, for a higher rate (bridging the low rates of borrowing for well rated AAA nations and very high rates of borrowing for the PIIGS) – all in the good cause of stabilising the eurozone. For Germany, this could reach 2% of GDP (over €600bn).

You might well ask ‘Well, if Germany or France are going to underwrite the EFSF and its €440bn capacity, and if Italy and Spain are ‘too big to fail’ and are beyond the capabilities of the EFSF thanks to their enormous size and economic importance, then surely Eurobonds are a risk worth taking?’

Fact is, yes, they probably are. And it would at the very least be a brave action in trying to tackle the crisis from the front rather than being constantly chased by it. But piggybacking on German fiscal prudence (no German excessive spending binges like in the PIIGS) was exactly what got the PIIGS in trouble in the first instance. For the Germans, it’s a case of ‘fool me once….’

And, of course. Eurobonds would make it easier for the problematic PIIGS to borrow, letting them off the noose, removing the pressure to get their economies in proper order and implement the necessary respective austerity plans. This is exactly what French President Sarkozy spoke of Eurobonds as a final act of eurozone fiscal integration, not the catalyst. This is Germany and France simply saying ‘We wont let you take advantage of us again. Not like last time. And anyway, you have to get your house in order.’

The PIIGS face some very tough (and vitally necessary) decisions to make. The choices are academic really. Its integrate or….well, its just integrate.

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