The EU's new bond isn't as solid as it seems

23 June 2020

10:00 PM

23 June 2020

10:00 PM

Its rescue fund will bail out the poorer states. It will fuel a rapid economic recovery. And perhaps most of all, it will finally turn the European Union into a fiscal union, raising its own money, and distributing it based on which region needs its most. The EU’s new €750 billion (£680 billion) rescue fund has been hailed as a huge step forward for the Union. Perhaps it will be. There is a problem, however. Some analysts are starting to argue the new shiny new EU bonds should be rated as junk – or something close to it.

On the surface, you might think an EU bond should be completely solid. After all, this is a £14.5 trillion economy, the largest single bloc in the world, with the world’s second-largest currency, the euro. It is only borrowing a fraction of GDP. In a world awash with debt, it should be able to raise the money, and lots more if it is needed, right? Well, here’s the problem. The EU has done the easy bit (promising to hand out lots of free cash) but has been a little slower on the harder bit (raising some taxes to pay back all that debt).

Even at very low interest rates, a bond needs some form of income to back it up. The EU is looking at new forms of direct taxes to repay the bonds. Plenty of fashionable ideas are under discussion, such as the inevitable green levies, and raiding the Apple piggy bank (otherwise known a digital services tax), along with more controversial proposals such a 0.5 per cent extra VAT rate, or an access fee to the single market. But none of them have been agreed yet and most of the 27 countries are very reluctant to let Brussels raise taxes directly. It could be years before a compromise is hammered out.

Even with new taxes in place, member states will be responsible for the debt. So, the argument runs, the bonds should be rated the same as the weakest member state. ‘Credit raters may not be on board with the EU’s assertion that these bonds, guaranteed by all the EU governments, would merit a super-high credit status,’ argued High Frequency Economics in a note this week. ‘To our eyes it would appear that the credit rating of the weakest guarantor of the Eurobonds ought to be the credit rating of the entire mutualised debt scheme.’

That makes sense. In truth, when it comes to repaying, the EU may ask each member to stump up its share, in which case you are relying on Greece, Portugal and Italy to come up with the cash. In the past, they have not always proved completely reliable. Greece has already defaulted on its debts five times, and it is rated at BB-minus, basically junk. Italy, with its exploding debt ratios, will be there soon. In truth, the EU’s bonds could easily be rated as high risk, and possibly even as junk.

Sure, it can probably still get the money. In the capital markets, €750 billion is not a huge sum, and there are plenty of hedge funds who buy some fairly rubbish bonds. But it will still create problems. For example, the European Central Bank may not be able to buy the paper, at least not without fudging the rules still further. Most of all it will be terrible for its image, and make the debt a lot more expensive. The so-called ‘coronabonds’ were meant to launch the EU on a new path to unity – junk isn’t the first word it would want attached to that project.

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