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Lost in La Mancha

21 April 2020 By Christopher Thompson

Credit to Pedro Sanchez for thinking big. The Spanish prime minister wants the European Union to use its budget to raise up to 1.5 trillion euros in perpetual bonds to pay for a post-virus economic recovery. It’s a smart move that could reduce the burden on struggling countries, but may not appeal to both bondholders and other member states.

Sanchez’s economic recovery plan is nothing if not ambitious. The funds, equivalent to a tenth of the EU’s GDP, would be disbursed next year beginning with the worst hit sectors like tourism, according to Spanish government documents. States would receive allocations according to transparent determinants, such as increases in redundancy.

Such a tool would at least help those most affected by the crisis, namely Spain and Italy. Moreover, as the bonds would be issued by the EU, backed by revenue collected by the European Commission and allocated as grants, not loans, they wouldn’t add to recipients’ borrowings. Goldman Sachs analysts reckon public debt in Italy and Spain will touch 161% and 115% of GDP respectively this year.

The plan also makes the most of the European Central Bank’s ultra-loose monetary policy, allowing interest costs to be fixed, permanently, at low rates. In 2006, Breakingviews suggested in a spoof column that the U.S. Treasury should issue zero coupon perpetual bonds. Such a ploy now seems almost too plausible.

The closest comparable bonds are some small, perpetual instruments issued many decades ago by the Netherlands, which currently yield around 90 basis points, according to Refinitiv. Assuming Sanchez’ bonds pay a premium of perhaps 30 basis points, in line with the difference between long-dated Dutch and EU bond yields, then the coupon might be 1.2%. That would imply around 18 billion euros in annual interest costs, or 9% of next year’s projected EU budget.

The challenge will be to persuade other member states to play ball. Using joblessness as an allocation metric could be problematic due to the lack of common labour laws.

The other obstacle is finding the money to service the bonds. Member states are already squabbling over the next EU budget. That may be why Spain is proposing using new EU-wide taxes, such as carbon duties. The snag is that such cash flows could be less predictable. Bond investors might demand a premium, and other members states would worry that they would have to cover any shortfall. Sanchez’s plan is sufficiently bold, but probably little more than an opening gambit.


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