With 1.902 billion euros of debt and 1.560 billion euros of income, Italy has a debt-to-GDP ratio of just under 122 percent. Worse than us is Japan, but the crisis has also caused the debt/GDP of France, Germany, the United Kingdom and the United States to take off. Debt containment, therefore, is common to all large democracies.
Greater growth, more tax revenues, devaluation, high inflation and debt restructuring do not seem to be solutions currently applicable in Italy because the reforms necessary for development require excessive time and unpopular choices, taxation is very high, the Euro has transferred the monetary policy in the hands of the ECB and the contagion effect of a member state's debt restructuring would drag the entire European Union into the abyss. In the run-up to debt, therefore, our boot not only starts from further away but also seems to have the most broken shoes.
The financial crisis has demonized complex financial products and the securitization that produced them. However, a solution to the debt problem could come from applying this mechanism to the debts of European Union countries by adding some elements typical of microfinance. The idea exploits the advantages of diversification, joint responsibility and price discrimination.
Each EU member country that wants to participate in a common European fund for sovereign debt restructuring issues debt according to various credit risk categories. For example, let us assume three categories: "green" debt, which having absolute repayment priority is the safest, "yellow" debt, less secure than the previous one, but with payment precedence over "red" debt, the riskiest and last part of the debt. In practice, when purchasing a BOT, each investor will choose according to their preferences whether to have a higher return with greater risk ("red" BOT) or sleep more peacefully by settling for lower interest ("green" BOTs). .
Since yields change as credit risk varies, the issuer can practice price discrimination: each investor buys at a price closer to the reserve price and leaves part of its surplus to the issuer which, for the same debt, will pay less interest overall. Currently, investors with different risk preferences who buy the same government bond receive the same returns: however, the more risk averse investor is willing to settle for lower interest rates in order to have certain returns. By offering the risk-averse investor securities in line with his risk and return profile, the state would save on the interest to be paid. The division into different risk categories can also facilitate diversification which today can only take place by incurring the information costs associated with the various securities included in the portfolio and the transition costs for each operation.
The next step requires that the acceding countries decide to pool their "green" debts in the common sovereign debt restructuring fund, against which the fund would issue a Eurobond whose shares of debt contributed by each country are negotiated between the participants in each issue. The dynamic nature of the Eurobond not only makes it possible to quickly adjust the composition of the bond to changing economic and financial conditions in the participating countries, but implicitly gives a strong signal to the markets on the direction and extent of the political agreement reached.
The financial transformation thus implemented would lower the rates of return with respect to the weighted average rate of the individual underlying bonds and the savings could be distributed pro-rata among the member countries, reducing their financial charges. The financial benefit would encourage adherence to the Eurobond while the bargaining of quotas would avoid adverse selection, ie the non-adhesion of the less indebted countries which are afraid to pay for the less reliable ones. By repeating the game at each issue, moral hazard is also eliminated, i.e. the opportunistic behavior of those who, despite being able to honor their debt, default strategically to pass it on to their partners.
Any opportunistic behavior by a country would be punished through mechanisms similar to those operating in microfinance. In fact, if a member country fails to pay its debt, it would automatically be sanctioned with exclusion from subsequent Eurobond issues, exactly as occurs in group lending contracts. Making a strategic default would also give up the possibility of increasing the amount of "green" debt transferred to the Eurobond on which a lower interest rate is paid, a mechanism similar to progressive lending. Finally, similarly to what happens in microfinance, joint accountability would incentivize each country to monitor partners by pressing to achieve budgetary, transparency and development policy objectives. This reciprocal monitoring would push countries towards fiscal union gradually, thus allowing the "virtuous" ones to sanction any opportunistic behavior of the "vicious" countries and the latter to adopt more stringent financial measures.
What role would “yellow” and “red” debt play? In addition to reaping the benefits of price discrimination, they would serve to limit the power of rating agencies. In the current condition, a credit rating downgrade penalizes all debt equally. With a progressive risk obligation, the tranches would be assessed individually: lowering their ratings simultaneously and uniformly would be an operation judged too superficial by the markets and the rating agency would risk damaging its reputation. The "yellow" debt could be securitized by geographical affinity, for example a South-Eurobond and a North-Eurobond. Fewer differences between states would make bargaining easier and given the complementarity with bargaining at the community level, this could reduce conflict in the latter too. The "red" debt would be a driving force: in the event of a strong speculative attack, it would quickly default, thus easing the pressure on the rest of the debt.
To make the proposal more concrete, consider the following example. A two-year Eurobond with an annual coupon of 5 percent is issued against two similar underlying "green" national debts, one German and one Greek: at current values, the former is 106,96 with an implied yield of 1,44 percent and the second 81,87 with a yield of 16,35 percent. The governments of Athens and Berlin negotiate the quotas, agreeing 94 percent to Germany and 6 percent to Greece. If the Eurobond auction fixed a price of 105,30, the implicit yield would be 2,26 percent, 8 basis points lower than the weighted average yield of the two underlying bonds, ie 2,34 percent. The market prices the lower information and transaction costs to achieve diversification. Since joint liability makes the Eurobond less risky than a similar portfolio of the same securities, its price could rise to, for example, 105,6. Finally, the agreement reached between the countries would give an important signal of political coordination: let's assume that the price reaches 105,75. The Eurobond would then have a yield of 2,04 percent. The saving of 30 basis points with respect to the weighted average yield would be distributed pro-rata: 28 basis points to Germany which would pay an interest of 1.16 percent and 2 to Greece bringing its interest rate to 16,33 percent. The advantages of the Eurobond are exponentially amplified as the number of participants increases. The stock would receive a rating of AAA effectively insulating part of the debt from ratings (sometimes questionable) ratings agencies. Finally, a possible default on a participating country's red debt would increase the probability of repaying its green debt with consequent savings on Eurobond interest rates and a stabilizing effect on the European bond. In short, the overall benefits, while difficult to quantify, should be relevant and deserve to be exploited.
Although the Sarkozy-Merkel meeting disappointed expectations and did not make substantial progress for German reserves, Eurobonds could ease Europe's public debt problems and lay the foundations for a fiscal union. A very first step towards the Eurobond can be considered the recent bailout fund. The limits of the EFSF are known: insufficient resources to deal with debt and banking crises in several countries, especially in the case of non-peripheral countries such as Italy. However, the major constraint of the EFSF could derive from the fact that it is the result of a one-off discretionary political agreement and not of economic-financial negotiation and therefore its adjustment to financial shocks could be too slow for the frenetic rhythms of the markets.
It is clear that the proposed scheme will have to be followed by medium-term measures that contain debt and above all promote growth in a structural manner. In short, a little coexistence before getting married could avoid ruinous immediate divorces and allow to overcome the first storms of married life but for a lasting European marriage more powerful elixirs are needed than a simple financial ploy.
*Economist of the Marche Polytechnic University
Attachments: Francesco_Marchionne.doc
