May 4, 2021, STEFANO MICOSSI, EMILIOS AVGOULEAS, ROME/EDINBURGH – The eurozone needs a new common policy to manage the sovereign debts accumulated by member states in response to the pandemic. The European Central Bank currently holds a large share of these debts, but it will need to unwind them when monetary-policy considerations warrant it. Whenever that process begins, it may cause turbulence in eurozone financial markets. That, in turn, would increase the cost of rolling over public debt, raising the specter of systemic instability in a banking sector that will have already been weakened by a new wave of nonperforming loans.
Owing to these concerns, ECB-held public debt should be kept out of financial markets indefinitely, by having the European Stability Mechanism purchase ECB-held government securities with funds generated by issuing its own euro liabilities. This can be done without any ESM Treaty changes, and without breaching treaty restrictions on debt mutualization.
The eurozone’s average sovereign debt-to-GDP ratio is expected to reach 102%, with seven countries close to or above 120% (Italy is at 160%, and Greece is above 200%). With nominal annual growth of around 3% (assuming inflation returns to 2% soon), bringing these debt ratios down to 60% in 20 years – as required under the (suspended) Stability and Growth Pact (SGP) – would require these countries to run sizeable primary surpluses of 2-4% of GDP.
But given the need to provide continuing support for the recovery, the traditional medicine of budgetary restraint to repay sovereign debt would not be compatible with debt sustainability. Moreover, it would limit member states’ ability to prevent the economic and social wounds inflicted by the pandemic from becoming permanent scars. And debt restructuring is not a viable option, either, because it would wreak havoc on highly indebted countries’ economies, potentially jeopardizing economic and financial stability across the eurozone. Ultimately, then, the current build-up of sovereign indebtedness cannot be left to member states to manage by themselves. Because the policy problems it raises affect all members, it must be addressed collectively. As of the beginning of 2021, the ECB’s sovereign securities holdings had exceeded €3 trillion ($3.6 trillion) – or about 30% of total outstanding sovereign debt in the eurozone and roughly the same share of the eurozone’s GDP. Ongoing pandemic-response programs may well add another €1.5 trillion before they are discontinued.
If these debts are not renewed at maturity, liquidity conditions could tighten as a result of member states placing equivalent securities on financial markets. To ensure eurozone financial resilience and prevent highly indebted countries from being pushed up against the wall, these sovereigns should be kept out of capital markets for a period longer than justified by pure monetary-policy considerations. It is nonsense to think that the refinancing of COVID-19 debt should be subject to market discipline, because this would simply penalize governments for protecting their citizens during the pandemic.
In other words, financial stability, not monetary policy, is the main reason to step in and manage outstanding sovereign debts in the eurozone. The task could not be permanently entrusted to the ECB without blurring the line between monetary policy and fiscal policy, as established by the EU Court of Justice in Gauweiler and others and Weiss and others. That is why we propose a new credit facility to enable the ESM gradually to acquire sovereigns held by the ECB, and to renew them indefinitely.
Under this arrangement, the sovereign risk would not be transferred to the ESM, but rather would remain with national central banks. The ESM would evolve into a eurozone debt-management agency, and since the cost of repayment would not move to the ESM, there would be no risk of breaching the European Treaty’s no-bailout clause.
To finance its sovereign purchases, the ESM would issue its own liabilities, which would be guaranteed by its sovereign portfolio, its ample capital, and ESM member states. The facility thus would establish an adequate basis for a large, deep, liquid market in a new European safe asset.
The ESM’s purchases would continue as long as necessary to reduce the average sovereign debt left with private investors in the eurozone to below 75% of GDP – a debt ratio that could be set (by amending the Treaty Protocol on excessive deficit procedures) as the bloc’s new debt-to-GDP benchmark. The facility would be established under Article 14 (pertaining to precautionary financial assistance) of the revised ESM Treaty. Accordingly, the macroeconomic conditionality attached to ESM financial assistance under Article 12 of the treaty would not apply. Instead, there should be light conditionality requiring adherence to general eligibility criteria sufficient to ensure eurozone financial stability. Naturally, a precondition for our scheme’s acceptance is that the SGP must be reformed to establish a more credible budgetary discipline regime.
Once implemented, our proposal would allow the ECB to regain its independence. No longer would its monetary-policy decisions be constrained by the need to maintain stable conditions in European sovereign-debt markets. Better yet, the issuance of large quantities of safe euro-denominated securities would relieve the interest-rate pressures on the German Bund and other “safe-haven” debt instruments in member states’ financial markets.
Finding a way to manage the mountain of eurozone debt accumulated during the pandemic could stabilize growth expectations and create a favorable environment for private-sector investment. Allowing the ESM to purchase from the ECB all eurozone COVID-19 debt in the way we propose can offer a permanent and credible solution to what otherwise threatens to become a vexing long-term problem.
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