EU bonds are a marathon effort, not a sprint

The message is loud and clear; whether it is the debt sustainability fears or the erratic trade policy from Washington, investors want an alternative to the US dollar. The world’s reserve currency, however, has one very large incumbent advantage: the $30tn Treasury bond market.

A necessary condition for any currency looking to take over the dollar’s lead is a sizeable safe asset that can act as a home for the world’s financial wealth. The only problem for investors is that another one does not really exist. The next best thing is the German Bund, but it is just not big enough, accounting for barely a tenth of the size of the market for US government debt. 

That is going to be a problem for those in Europe, sensing an opportunity to capitalise on the zeitgeist and propel the euro to a more prominent position on the global stage.

European ambitions are not limited to taking a bigger slice of the global reserve market. With war on its doorstep and the US seemingly retreating from its role as the world’s policeman, it also needs to beef up its own military might. 

A large, deep and liquid capital market is one of the three pillars identified by European Central Bank president Christine Lagarde in a recent speech on increasing the euro’s global status. Collective European debt would then come in very handy to meet the ends of a reserve currency and rearmament today.

The central bank might be able to help in the process, but the power to really make this happen lies with Europe’s politicians. 

Where are we today?

We are closer to a collective market for European debt than you might think. The shock of the pandemic allowed the EU to break down some taboos in collective debt finance.

The Next Generation EU plan adopted in 2020 aimed to direct €800bn of spending into pandemic recovery efforts, green energy and digital infrastructure. So far, about half the money has been raised and is expected to tap bond markets for an additional €160bn this year. Including other EU debt issues, such as those from the financial crisis bailouts, the total market for EU debt could hit about €1tn in the next few years.

Though that is a large sum, it is far too small to fill the criteria for a reserve currency. There are two paths forward, one radical and possible; the other is slower, but more likely.

A radical path

A recent suggestion in the radical camp has come from Olivier Blanchard and Ángel Ubide, published by the Peterson Institute for International Economics. The pair envisage a transformation that would exchange a portion of EU member national debt, 25 per cent of GDP in their estimation, into new EU bonds to create a market worth about €5tn.

That would be big enough to tick the box for a large, deep and liquid market that provides the safe asset criteria for a reserve currency. It should lower borrowing costs not only for sovereign members but also spread out into the corporate curve and lower private borrowing costs. 

It is an idea with deep logical foundations, but outside of a crisis and one that is presumably worse than a pandemic, such a radical shift seems unlikely in the practicalities of EU politics.

A transition

A slower approach would be much more in keeping with political norms. The state of the existing EU market debt offers some clues to the likely evolution. One of the market’s biggest hang-ups with the NGEU bonds is uncertainty about what happens next. Will there still be a market for EU debt when they are due to be repaid in 2058? This is one reason why the yields on the debt trade at a premium to German Bunds. Other reasons are the lower liquidity than bigger debt markets, and the fact that the bonds are classed as supranationals rather than sovereigns and thus excluded from sovereign indices.

That said, the market’s foundations include a functioning curve for the debt, a declining spread to Bunds and a repo market for them is already functioning. 

The crux of the issue though comes down to who is going to pay for them. The current agreement is that the EU meets the interest payments and how it does so remains a matter of contention. As it stands, the money comes out of the existing EU budget collected from annual member contributions.

“Five years down the line the EU has still not reached a firm agreement on new resources to address the repayments of borrowings for the Next Generation grants other than to meet obligations from the general budget,” says Alexander Ekbom, EU rating analyst at S&P.

While other revenue sources such as carbon or corporate taxes have been floated to pay the interest costs, lack of agreement means the decision has been pushed back until the EU’s next Multiannual Financial Framework long-term budget that arrives in 2028. 

“It took a major shock to get the EU to agree to collective debt issuance in 2020, the next steps are likely to be much more gradual in the absence of a material external shock. But with Brussels taking a more active role, for example, in the defence policy I expect to see further issuance in the future and for that to be reflected in the next long-term budget negotiations,” says Sören Radde, of hedge fund Point72.

The ECB’s role

How might the ECB assist the transition to a bigger market for EU bonds? It could make a commitment to include EU bonds when it makes its decisions about its structural portfolio, the bonds from the quantitative easing era that it plans to hold on to indefinitely in case it ever has to step back into the market. Offering the same support for EU bonds on offer to sovereigns would certainly be a comfort for investors. 

The EU, euro and the EU bond market might not be able to seize the day from the dollar for the time being, but the direction of travel suggests they can still seize the decade.