Europe’s Dream Of Safe Assets to Rival Treasuries Gets Boost

(Bloomberg) -- For Europe’s integrationists, a jointly issued bond with the safety and liquidity to rival U.S. Treasuries is necessary to ensure the bloc’s stability. Germany and France may have taken a small, first step toward creating such a European safe asset.

In a landmark intervention, German Chancellor Angela Merkel and French President Emmanuel Macron agreed to support a 500 billion-euro ($546 billion) aid package financed through the issuance of bonds by the European Union’s executive arm. While the proposal for the creation of a recovery fund still needs to be approved by the other member states, it indicates the acceptance -- albeit in a limited fashion -- of a more wide-ranging supranational asset.

The reaction from markets was clear -- Italian bonds surged and the euro rallied -- but concerns remain over whether the package is big enough to create a market of its own. For ING Groep NV, the temporary nature of the recovery effort may be a problem in creating a meaningful alternative to the German bund, which has long been deemed the safest government-backed asset in Europe.

“Five hundred billion euros is not huge,” said James Athey, a money manager at Aberdeen Standard Investments. “But it looks like a solid first step.”

Separately, on Tuesday, EU finance ministers agreed to allow the European Commission to borrow 100 billion euros, which will then be channeled to the countries hit hardest by the pandemic in the form of concessional loans. The issuance by the EU executive will be backed by the bloc’s common budget and paid-in guarantees of 25 billion euros. Germany will chip in the most for the guarantees and is the biggest contributor to the EU budget.

Over the past decade, EU officials in Brussels and Frankfurt have advocated for the creation of a European safe asset, a jointly issued debt instrument that could act as a benchmark for other securities and would be comparable to U.S. Treasury securities.

This EU-issued debt has been seen as a key step in the European integration process, as it would help banks diversify their bond portfolio, and break the so-called doom loop created when lenders hold a disproportionate amount of their home countries’ securities. In 2019, the commission said a safe asset would also reduce destabilizing capital flows during periods of elevated risk, when investors tend to move money into safer securities.

A European benchmark is also seen as a key part of Europe’s ambition to challenge the dollar’s global dominance, and boost the role of the euro as an international reserve currency. Time and again, European governments have seen the dollar’s privilege in the world stage constraining their ability to enact foreign policy, most recently when the U.S threatened sanctions against companies doing business with Iran, dooming an international accord that had curtailed Tehran’s nuclear plans.

The Franco-German plan would still need unanimous support from all 27 EU members, and even then the recovery fund wouldn’t be ready until 2021, according to French Finance Minister Bruno Le Maire.

“A safe asset will need to be based on continuous issuance so that a market with good liquidity (along the curve) can develop,” UniCredit Group chief economist Erik Fossing Nielsen said. “In contrast, this is a one-off, and even if you were to believe that they would continuously repeat the event on an ad hoc basis going forward,” markets would need more certainty and clarity to treat the securities as risk free, he said.

Monetary Tool

There are clear advantages for the ECB. It is currently constrained in its quantitative easing program to purchase only a certain proportion of a country’s debt to avoid blurring the lines of independence. The creation of a joint debt instrument would help alleviate those concerns, giving it something to buy as it cushions the economic blow from the coronavirus.

ECB President Christine Lagarde praised the proposal as “ambitious, targeted and, of course, welcome.”

The need to come up with joint bonds has become more acute as countries across the region have locked down their economies to halt the spread of the virus. Those hardest hit -- like Italy and Spain -- are also those with some of the highest debt loads in the region, limiting their capacity to spend money on shoring up the economy.

Italy’s 10-year yield spread over Germany, a key gauge of political risk in the country, spiked to the highest level in over a year in March, before the ECB stepped in to cap borrowing costs. The Franco-German proposal saw the gap narrow to 206 basis points, around the lowest level in a month.

Rome has been an ardent supporter of joint bonds to finance the recovery effort, and after Monday’s proposal, expressed support for the intiative, calling it a step in the right direction, according to an official.

Limited Scope

For Antoine Bouvet, a senior interest-rate strategist at ING, the duration of the debt may be limited by the EU’s budget, which operates over a period of seven years. That would prevent the bloc from building out a full yield curve -- the issuance of bonds of various maturities, typically out to 30 years.

“As a temporary instrument, and as its size will be limited, it will fall short of a replacement to the fragmented euro government bond market which I think would be the ultimate goal of a European safe asset,” said Bouvet. “After that, it should be paid back by member states or by other sources of financing.”

Key concerns also focus on how the proceeds of the recovery fund will be distributed. Credit lines from the ESM have proved unpopular in Italy -- particularly to the far-right leader Matteo Salvini -- due to the perceived strings attached to the loans.

“If Italy doesn’t get its ‘fair share’ then it’s gold for Salvini,” said Aberdeen’s Athey. “It could be another political nightmare.”

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