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France's Macron nudges European debt mutualization closer to reality

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Investment Banking Essentials: February 21

France's Macron nudges European debt mutualization closer to reality

The election of Emmanuel Macron as president of France has breathed new life into plans for common eurozone bonds, but Germany remains ideologically opposed to the plan and bond specialists are unsure about its overall impact on borrowing costs.

The European Commission published a 'reflection paper' on May 31 raising the possibility of issuing bonds backed by diversified pools of eurozone government debt, effectively a securitization of sovereign bonds, dubbed Sovereign Bond-Backed Securities, or SBBS.

While this stops short of full-on debt mutualization, an idea considered anathema by Germany, Macron's election on a strongly pro-European platform has added credibility to persistent calls for a deepening of economic and monetary union in the bloc, aimed at narrowing the gap between borrowing costs of stronger and weaker economies in the long term.

However, whether the SBBS instruments would actually have a positive overall impact on the borrowing costs of weaker eurozone economies is unclear.

"If it was a zero-sum game then you could say core yields would rise a little and periphery yields would come in, but there are complexities," said one head of sovereign debt capital markets at a European bank. "The SBBS is not mutualization, it is more of a hybrid idea, so there would only be an incremental effect on spreads."

Other bond bankers said many non-EU investors may welcome an instrument akin to U.S. Treasuries to get exposure to Europe, but they agreed that the sketchy details of the plan raised more questions than answers.

"The question is what happens to the bonds that don't go into this structure," said one government bond syndicate banker in London. "You could argue that hypothetically it's the same as Treasuries and municipal debt from states in the U.S., but they obviously have a common treasury. Yields on periphery bonds that weren't included in the new 'safe' asset would surely rise."

Joint debt 'absolutely necessary'

The debt mutualization argument goes to the heart of the debate about the future direction of the eurozone, which has been taken on new significance since Macron won the French presidential election, during which he called for a common eurozone budget and a eurozone finance minister. Polls show Macron's new centrist party, En Marche!, is set to win a majority in legislative elections to be held over two rounds on June 11 and June 18.

"It will definitely get more tailwind from Macron's election," said Florian Hense, an economist at Berenberg in London. "The question is how the risk-sharing is managed."

German Chancellor Angela Merkel, and her Finance Minister Wolfgang Schaeuble, have consistently rejected any idea of debt mutualization for the 19 euro members, saying it would encourage irresponsible borrowing by weaker economies and delay structural reforms.

"Plans to go down that road are more realistic if they have clear limits to debt mutualization," said Hense. "It is not completely unrealistic to see debt being pooled up to the 60% of GDP limit of the Maastricht treaty, even that would be a big revolution, but maybe not until 2030.

"There are figures in Merkel's [Christian Democrat] party that would never sign up to it, but in a few years if France is picking up and there is no reversal of reform in the periphery then the German position could soften."

Government borrowing costs in the eurozone have diverged sharply since the debt crisis. Germany's 10-year debt currently yields just 0.3%, while Portugal's comparable yield is 3.1% and Greece's is over 6%.

The Greek yield was nearly 11% in March 2015, before the European Central Bank began buying government bonds as part of its quantitative easing policy. The central bank has since acquired some €1.5 trillion of eurozone sovereign bonds, but is expected to stop buying altogether at some point in 2018, and the withdrawal of central bank support could see weaker economies' borrowing costs begin to rise once more.

Speaking at the Brussels Economic Forum on June 1, the European Commissioner for Economic and Financial Affairs, Pierre Moscovici, said common eurozone bonds would help sever the 'doom loop' between the borrowing costs of banks and their domestic sovereigns, caused by banks holding large amounts of their own governments' bonds.

"In the short-to-medium term, sovereign bond-backed securities could serve that purpose. But in the longer run, the development of a genuine euro area safe asset is absolutely necessary," he said.

Macron momentum

Any pooling of debt is still a long way off - the Commission paper said the instruments could be introduced between 2020 and 2025, as part of "completing the Economic and Monetary Union architecture."

But for the Commission, one of the EU's four governing institutions alongside the ECB, the European Parliament and the European Council, to be talking in such terms about common bonds represents a marked shift in the momentum behind further integration.

Merkel enthusiastically welcomed the victory of Macron, despite his calls for the creation of a eurozone treasury, and at a recent meeting the pair discussed the possibility of altering EU treaties to allow further integration between member states in certain areas.

"Macron knows that shifting German policy will be hard," said Charles Grant, director of the Centre for European Reform, in a note published May 24.

"His plan is to impress the Germans by reforming France – for example by cutting the non-wage costs of employment, lowering the state’s share of economic output and introducing Nordic-style active labor market policies. He hopes that success will give him the credibility to go to Berlin and propose a concordat on the euro and much else."

Macron's chances of achieving such reform have been boosted by polls ahead of the French parliamentary elections. His En Marche! party is on course to win an absolute majority, with between 335 and 355 seats in the 577-seat National Assembly, according to an OpinionWay/ORPI poll on June 1. The poll predicted En Marche! would receive 29% of votes in the first round, ahead of the conservative Republicans on 20% and the far-right National Front on 18%.