Guest Viewpoint: Is Europe on its way to becoming sovereign? | Characteristics
The EU is rapidly becoming a major player in capital markets and a major provider of safe euro assets, thus strengthening the international role of the euro. The financing of a considerable part of NGEU by green bonds means that the EU – as the leader in the issuance of green bonds – will manage the largest green bond system in the world. For the first time, there is an intrinsic fiscal stabilization effect for the EU budget.
More than 10 years ago, in response to the European sovereign debt crisis, the new European Stability Mechanism (ESM) had a lending capacity of 60 billion euros. At the same time, the European Financial Stability Facility (EFSF) was endowed with an additional 400 billion euros, bringing the combined firewall to around 500 billion euros. In 2020, the EU had a total of €800 billion in safe assets – i.e. European Commission (EC) issuance, ESM Pandemic Crisis Support and Bank funding European Investment Bank (EIB) – which is expected to reach nearly €2,000,000 over the next few years. Adding double-A and triple-A issuers, such as Germany and the Netherlands, the issuance of European safe assets could represent around 5 to 5.5 billion euros. However, this is still not enough. The United States holds about 90% of GDP in safe assets, compared to 40% of GDP in Europe.
To be able to overcome different crises, different tools are needed. The current pandemic has hit countries very symmetrically, unlike the global financial crisis, when the impact was more heterogeneous across countries. While for the latter – where reforms and restructuring were needed – the MES toolkit proved very useful, COVID-19 requires a very different approach.
Having an EU-27 blended bond like the one proposed under the NGEU program could pave the way for a truly European safe asset. Borrowings from the NGEU will be used for loans and, for the first time, to fund grants.
In the context of the NGEU, the EC acts as a de facto sovereign issuer. This requires building a primary dealer network with 42 banks, launching the EU-Bill program, launching bond auctions, maintaining regular communication with investors through funding plans, engaging with Member States and Debt Management Offices (DMOs), as well as trying to broaden the investor base to reach investors around the world; 13% of Emergency Unemployment Risk Mitigation Support (SURE) bonds are sold to foreign investors, and about 10% of NGEU bonds. The aim is to put the EU on the path as a benchmark green bond issuer and build a liquid curve of five to 30 years.
A very important difference with a sovereign issuer that has ongoing funding needs is that the EC issues debt for different policies. Even so, there are two important consequences.
First, issuance is very closely linked to the spending needs of the European economy, both in terms of timing and amount.
Second, debt issuance is limited and will cease in 2026 for the NGEU. It remains to be seen whether this will prevent the EU from achieving liquidity similar to that of France and Germany. However, the refinancing could go beyond 2026 for another 10 years, until 2036.
The EC has looked to the market to fund identifiable social and economic recovery needs, also adding a touch of sustainability to the process. Thus, the issuance of EU debt can take place without crowding out member states, since the Commission is funding complementary needs at a different level of government.
“The EU can offer international investors an instrument they can trust and trade with for diversification purposes”
On the market side, there is a huge appetite for highly liquid and highly rated European debt. This is evident from the high levels of oversubscription (more than 11x) for NGEU and SURE transactions. Factors such as the search for security, the scarcity of safe assets and the need for collateral contribute to this demand. For example, regarding the scarcity of safe assets, only around 10% of German debt is actually available to all investors. Having a safe EU asset would help reduce this scarcity. But also in terms of liquidity, EU debt is now at par with sovereign debt, a big change from pre-pandemic Europe.
Market borrowing can be a useful component of the EU budget, in particular to meet longer-term financing needs. The EU budget remains small as a percentage of GDP (at around 1% of total EU GDP). However, augmented by an additional amount of borrowing of up to 0.6% of GDP per year, NGEU borrowing can have a real impact on the EU as a whole.
What should not be overlooked, given that Europe wants to establish itself as a leader in green bonds, is the fact that around 30% of EU debt is green. In terms of ESG bond issuance year-to-date, Europe leads, accounting for more than half of global issuance. Moreover, 60% of this is represented by sovereign governments or sovereign and supranational issuers.
With the NGEU Green Bond Scheme, Member States have allocated more than €240 billion of their spending to climate-related spending. This amount will be checked regularly by the EC in order to ensure that the use of the proceeds finances or refinances projects in conformity with the taxonomy regulation. Thus, disclosure and impact reporting are crucial elements of the program. However, there are certain expenses like climate research, social skills, and scaling that climate taxonomy does not take into account. So there may be things that governments spend money on that are not covered by the taxonomy.
Finally, the Commission’s issuance program is also having a positive impact in terms of increased recognition of the euro by international capital markets. The EU can offer international investors an instrument they can trust and trade with for diversification purposes. For the first time, thanks to the NGEU, there is an inherent fiscal stabilization effect for the EU budget. This in itself helped to avoid the flight to safety at the start of the crisis and kept interest rates on a narrow path.
Moreover, EU debt issuance will not break the catastrophic sovereign loop in itself, but is an alternative tool to sovereign debt issuance. Overall, diversification away from domestic sovereigns strengthens banks’ balance sheets.
Dr Apostolos Thomadakis is a researcher at the European Capital Markets Institute (ECMI), an independent research institute run by the Center for European Policy Studies (CEPS)