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Achtung Baby

28 November 2011 By Neil Unmack

Fears that Germany will have to underwrite the debt of other euro zone countries have pushed up the country’s bond yields in recent weeks. Common bonds would end the country’s days of super-cheap borrowing. But if it was part of a genuine fiscal union, funding costs need not go sky high.

Judging by current sovereign spreads, a common bond would be expensive. Since the bond would effectively combine the credit risk of the euro zone’s 17 different members, the yield should be the average of all the countries’ borrowing costs, adjusted for size of their economies. According to calculations by Thomson Reuters, the weighted average yield on 10-year debt is currently 5.1 percent – nearly three percentage points above Germany’s borrowing costs.

However, the current market panic means bond prices are hardly representative. The European Central Bank is not currently acting as a lender of last resort. Investors are pricing in the possibility that the euro will crack, and that some countries will revert to their national currencies.

If the euro zone truly embraced political union, investors might view it as a single economy. Its debt today would be 90 percent of GDP – similar to that of France. Though French borrowing costs are strained today, it has over the past 25 years paid an average of just 65 basis points more than Germany for 10-year debt.

Moreover, the market for euro zone bonds would be deeper and more liquid than for national debt. The euro would become a reserve currency to rival the dollar. And if governments agreed to greater fiscal integration, the ECB would have greater freedom to intervene.

Assume a liquidity benefit of between 10-20 basis points – in line with recent estimates by the European Commission – and the extra cost for Germany would be between 45 and 55 basis points. That’s hardly disastrous.

However, the risk is moral hazard. The euro zone might fail to adequately sanction governments. Investors might doze off again, as they did in the first years of the euro’s existence. The creditworthiness of the single euro zone might initially resemble France, but end up more like Italy. In that case, Germany would face a larger bill for surrendering its fiscal sovereignty. The hidden costs of a common bond could be far higher than the explicit ones.


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