# EUR-Lex - 52011DC0818 - EN

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# 52011DC0818

**GREEN PAPER on the feasibility of introducing Stability Bonds /* COM/2011/0818 final */**

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GREEN PAPER

on the feasibility of introducing
Stability Bonds

1.
Rationale and pre-conditions for stability bonds[1]
1.1.
Background

This Green Paper has the objective to
launch a broad public consultation on the concept of Stability Bonds, with all relevant stakeholders and interested parties, i.e. Member
States, financial market operators, financial market industry associations,
academics, within the EU and beyond, and the wider public as a basis for
allowing the European Commission to identify the appropriate way forward on
this concept.

The document assesses the feasibility of
common issuance of sovereign bonds (hereafter "common issuance")
among the Member States of the euro area and the requiredconditions[2]. Sovereign issuance in the euro area is currently conducted by
Member States on a decentralised basis, using various issuance procedures. The
introduction of commonly issued Stability Bonds would mean a pooling of
sovereign issuance among the Member States and the sharing of associated
revenue flows and debt-servicing costs. This would significantly alter the
structure of the euro-area sovereign bond market, which is the largest segment
in the euro-area financial market as a whole (see Annex 1 for details of
euro-area sovereign bond markets).

The concept of common issuance was first
discussed by Member States in the late 1990s, when the Giovannini Group (which has advised the Commission on capital-market developments
related to the euro) published a report presenting a range of possible options
for co-ordinating the issuance of euro-area sovereign debt[3]. In September 2008, interest in
common issuance was revived among market participants, when the European
Primary Dealers Association (EPDA) published a discussion paper "A Common
European Government Bond"[4].
This paper confirmed that euro-area government bond markets remained highly
fragmented almost 10 years after the introduction of the euro and discussed the
pros and cons of common issuance. In 2009, the Commission services again
discussed the issue of common issuance in the EMU@10 report.

The intensification of the euro-area
sovereign debt crisis has triggered a wider debate on the feasibility of common
issuance[5]. A significant number of political
figures, market analysts and academics have promoted the idea of common
issuance as a potentially powerful instrument to address liquidity constraints
in several euro-area Member States. Against this background, the
European Parliament requested the Commission to investigate the feasibility of
common issuance in the context of adopting the legislative package on euro-area
economic governance, underlining that the common issuance of Stability Bonds
would also require a further move towards a common economic and fiscal policy[6].

While common issuance has typically been
regarded as a longer-term possibility, the more recent debate has focused on potential
near-term benefits as a way to alleviate tension in the sovereign debt market. In this context, the introduction of Stability Bonds would not come
at the end of a process of economic and fiscal convergence, but would come in
parallel with further convergence and foster the establishment and
implementation of the necessary framework for such convergence. Such a parallel
approach would require an immediate and decisive advance in the process of
economic, financial and political integration within the euro area.

The Stability Bond would differ from
existing jointly issued instruments. Stability Bonds
would be an instrument designed for the day-to-day financing of euro-area general
governments through common issuance. In this respect, they should be
distinguished from other jointly issued bonds in the European Union and euro
area, such as issuance to finance external assistance to Member States and
third countries[7].
Accordingly, the scale of Stability Bond issuance would be much larger and more
continuous than that involved in the existing forms of national or joint
issuance.

Issuance of Stability Bonds could be
centralised in a single agency or remain decentralised at the national level
with tight co-ordination among the Member States.
The distribution of revenue flows and debt-servicing costs linked to Stability
Bonds would reflect the respective issuance shares of the Member States.
Depending on the chosen approach to issuing Stability Bonds, Member States could
accept joint-and-several liability for all or part of the associated debt-servicing
costs, implying a corresponding pooling of credit risk.

Many of the implications of Stability
Bonds go well beyond the technical domain and involve issues relating to national
sovereignty and the process of economic and political integration. These issues include reinforced economic policy coordination and
governance, and a higher degree of economic convergence, and, under some
options, the need for Treaty changes. The more extensively credit risk would be
pooled among sovereigns, the lower would be market volatility but also market
discipline on any individual sovereign. Thus fiscal stability would have to
rely more strongly on discipline provided by political processes. Equally, some
of the pre-conditions for the success of Stability Bonds, such as a high degree
of political stability and predictability or the scope of backing by monetary
authorities, go well beyond the more technical domain.

Any type of Stability Bond would have to
be accompanied by a substantially reinforced fiscal surveillance and policy
coordination as an essential counterpart, so as to avoid moral hazard and
ensure sustainable public finances and to support competitiveness and reduction
of harmful macroeconomic imbalances.

This would necessarily have implications
for fiscal sovereignty, which calls for a substantive debate in euro area
member states.

As such issues require in-depth
consideration, this paper has been adopted by the Commission so as to launch a
necessary process of political debate and public consultation on the
feasibility of and the pre-conditions for introducing Stability Bonds.

1.2.
Rationale

The debate on common issuance has
evolved considerably since the launch of the euro.
Initially, the rationale for common issuance focused mainly on the benefits of
enhanced market efficiency through enhanced liquidity in euro-area sovereign
bond market and the wider euro-area financial system. More recently, in the
context of the ongoing sovereign crisis, the focus of debate has shifted toward
stability aspects. Against this background, the main benefits of common
issuance can be identified as:

1.2.1.
Managing the current crisis and preventing
future sovereign debt crises

The prospect of Stability Bonds could potentially
alleviate the current sovereign debt crisis, as the high-yield Member States
could benefit from the stronger creditworthiness of the low-yield Member States. Even if the introduction of Stability Bonds could take some time
(see Section 2), prior agreement on common issuance could have an impact
on market expectations and thereby lower average and marginal funding costs for
those Member States currently facing funding pressures. However, for any such
effect to be durable, a roadmap towards common bonds would have to be
accompanied by parallel commitments to stronger economic governance, which
would guarantee that the necessary budgetary and structural adjustment to
assure sustainability of public finances would be undertaken.

1.2.2.
Reinforcing financial stability in the euro area

Stability Bonds would make the euro-area
financial system more resilient to future adverse shocks and so reinforce
financial stability. Stability Bonds would provide
all participating Member States with more secure access to refinancing,
preventing a sudden loss of market access due to unwarranted risk aversion
and/or herd behaviour among investors. Accordingly, Stability Bonds would help
to smooth market volatility and reduce or eliminate the need for costly support
and rescue measures for Member States temporarily excluded from market
financing. The positive effects of such bonds are dependent on managing
the potential disincentives for fiscal discipline. This aspect will be
discussed more thoroughly in Section 1.3 and Section 3.

The euro-area banking system would
benefit from the availability of Stability Bonds.
Banks typically hold large amounts of sovereign bonds, as low-risk, low-volatility
and liquid investments. Sovereign bonds also serve as liquidity buffers,
because they can be sold at relatively stable prices or can be used as
collateral in refinancing operations. However, a significant home bias is
evident in banks' holdings of sovereign debt, creating an important link
between their balance sheets and the balance sheet of the domestic sovereign. If
the fiscal position of the domestic sovereign deteriorates substantially, the
quality of available collateral to the domestic banking system is inevitably
compromised, thereby exposing banks to refinancing risk both in the interbank
market and in accessing Eurosystem facilities. Stability Bonds would provide a
source of more robust collateral for all banks in the euro area, reducing their
vulnerability to deteriorating credit ratings of individual Member States.
Similarly, other institutional investors (e.g. life insurance companies and
pension funds), which tend to hold a relatively high share of domestic sovereign
bonds, would benefit from a more homogenous and robust asset in the form of a
Stability Bond.

1.2.3.
Facilitating transmission of monetary policy

Stability Bonds would facilitate the
transmission of euro-area monetary policy. The
sovereign debt crisis has impaired the transmission channel of monetary policy,
as government bond yields have diverged sharply in highly volatile markets. In
some extreme cases, the functioning of markets has been impaired and the ECB
has intervened via the Securities Market Programme. Stability Bonds would
create a larger pool of safe and liquid assets. This would help in ensuring
that the monetary conditions set by the ECB would pass smoothly and
consistently through the sovereign bond market to the borrowing costs of
enterprises and households and ultimately into aggregate demand.

1.2.4.
Improving market efficiency

Stability
Bonds would promote efficiency in the euro-area sovereign bond market and in
the broader euro-area financial system. Stability
Bond issuance would offer the possibility of a large and highly liquid market,
with a single benchmark yield in contrast to the current situation of many
country-specific benchmarks. The liquidity and high credit quality of the Stability
Bond market would deliver low benchmark yields, reflecting correspondingly low
credit risk and liquidity premiums (see Box 1). A single set of “risk
free” Stability Bond benchmark yields across the maturity spectrum would help
to develop the bond market more broadly, stimulating issuance by non-sovereign
issuers, e.g. corporations, municipalities, and financial firms. The
availability of a liquid euro-area benchmark would also facilitate the
functioning of many euro-denominated derivatives markets. The introduction of Stability
Bonds could be a further catalyst in integrating European securities
settlement, in parallel with the planned introduction of the ECB's Target2
Securities (T2S) pan-European common settlement platform and possible further
regulatory action at EU level. In these various ways, the introduction of Stability
Bonds could lead to lower financing costs for both the public sector and the
private sector in the euro area and thereby underpin the longer-term growth
potential of the economy.

Box 1: The expected yield of Stability Bonds – the
empirical support

The introduction of Stability
Bonds should enhance liquidity in euro-area government bond markets, thereby
reducing the liquidity premium investors implicitly charge for holding
government bonds. This box presents an attempt to quantify how large the cost
savings through a lower liquidity premium could be. A second component of the
expected yield on Stability Bonds, namely the likely credit risk premium has
proven more controversial. Both the liquidity and credit premiums for a
Stability Bond would crucially depend on the options chosen for the design and
guarantee structure of such bonds.

Several empirical analyses compared the yield of
hypothetical commonly-issued bonds with the average yield of existing bonds.
These analyses assume that there is neither a decline in the liquidity premium
nor any enhancement in the credit risk by the common issuance beyond the
average of the ratings of Member States. Carstensen (2011) estimated that the
yield on common Bonds, if simply a weighted average of interest rates of Member
States, would be 2 percentage points above the German 10-year Bund. Another
estimate (Assmann, Boysen-Hogrefe (2011), ) concluded that the yield difference
to German bunds could be 0.5 to 0.6 of a percentage point. The underlying
reasoning is that fiscal variables are key determinants of sovereign bond
spreads. In fiscal terms, the euro-area aggregate would be comparable to France;
therefore the yield on common bonds would be broadly equal to that on French
bonds. An analysis by J.P Morgan (2011), using a comparable approach, yields a
similar range of around 0.5 to 0.6 of a percentage point. A further analysis
along these lines by the French bank NATIXIS (2011) suggests that common bonds
could be priced about 20 basis points above currently AAA-rated bonds. Favero
and Missale (2010) claim that US yields, adjusted for the exchange rate
premium, are a good benchmark for yields on common bonds, because such bonds
would aim to make the euro-area bond markets similar to the US market in terms
of credit risk and liquidity. They find that in the years before the financial
crisis the yield disadvantage of German over US government bonds was around 40
basis points, which would then represent the liquidity gains obtained from
issuing common bonds under the same conditions as US bonds.

In order to provide an estimate of the attainable
gains in the liquidity premium, the Commission has conducted a statistical
analysis of each issuance of sovereign bonds in the euro area after 1999. The
size of the issuance is used as an approximation (as it is the most broadly
available indicator even if it might underestimate the potential gain in
liquidity premia) of how liquid a bond issuance is, and the coefficient in a
regression determines the attainable gains from issuing bonds in higher volumes[8]. A first model is
estimated using data on AAA-rated euro-area Member States (labelled "AAA"
in the table), and a second model is estimated using data on all available
euro-area Member States (labelled "AA"). The second model also
controls for the rating of each issuance. It emerges that all coefficients are
significant at conventional levels, and between 70 and 80% of the variation is
explained by the estimation.

To obtain the gain in the liquidity
premium, the coefficients from the model estimate were used to simulate the
potential fall in yields of bonds that were issued in the average US issuance
size rather than the average euro-area issuance volume. Hence, the US’s
issuance size serves as a proxy for how liquid a Stability Bond market might become.
In a first set of calculation, the liquidity advantage was derived from the average
historical “portfolio” yield since 1999. For comparison, the same calculations
were made assuming the market conditions of summer 2011.

The table's second
row indicates that the yield gain due to higher issuing volume would be in the
range of 10 to 20 basis points for the euro area, depending on the credit
rating achieved, but rather independent on whether the historical or recent
market conditions were used. The corresponding gain in the yield for Germany
would be around 7 basis points. The simulations demonstrate that the expected gain
in the liquidity premium is rather limited and decreases for Member States that
already benefit from the highest rating.

While it is obvious that
the Members States currently facing high yields would benefit from both the
pooling of the credit risk and the improved liquidity of the common bonds, the
current low-yield Member States could face higher yields in the absence of any
improvement in the credit risk of the current high-yield issuers. In principle,
compensatory side payments could redistribute the gains associated with the
liquidity premium, but in the absence of better governance the overall credit
quality of the euro area debt could in fact deteriorate as a result of weaker
market discipline to the extent that the current low-yield Member States would
face increased funding costs.

1.2.5.
Enhancing the role of the euro in the global
financial system

Stability Bonds would facilitate portfolio
investment in the euro and foster a more balanced global financial system. The US Treasury market and the total euro-area sovereign bond
market are comparable in size, but fragmentation in euro-denominated issuance
means that much larger volumes of Treasury bonds are available than for any of
the individual national issuers in the euro area. On average since 1999, the
issuance size of 10-year US Treasury bonds has been almost twice the issuing
size of the Bund and even larger than bonds issued by any other EU Member State.
According to available data, trading volumes in the US Treasury cash market are
also a multiple of those on the corresponding euro-area market, where liquidity
has migrated to the derivatives segment. High liquidity is one of the factors
contributing to the prominent and privileged role of US Treasuries in the
global financial system (backed by the US dollar as the sole international
reserve currency), thereby attracting institutional investors. Accordingly, the
larger issuance volumes and more liquid secondary markets implied by Stability
Bond issuance would strengthen the position of the euro as an international
reserve currency.

1.3.
Preconditions

While Stability Bonds would provide
substantial benefits in terms of financial stability and economic efficiency,
it would be essential to address potential downsides. To this end, important economic, legal and technical preconditions
would need to be met. These pre-conditions, which could imply Treaty changes
and substantial adjustments in the institutional design of EMU and the European
Union, are discussed below.

1.3.1.
Limiting moral hazard

Stability Bonds must not lead to a
reduction in budgetary discipline among euro-area Member States. A notable feature of the period since the launch of the euro has
been inconsistency in market discipline of budgetary policy in the
participating Member States. The high degree of convergence in euro-area bond
yields during the first decade of the euro was not, in retrospect, justified by
the budgetary performance of the Member States. The correction since 2009 has
been abrupt, with possibly some degree of overshooting. Despite this
inconsistency, the more recent experience confirms that markets can discipline
national budgetary policies in the euro area. With some forms of Stability
Bonds, such discipline would be reduced or lost altogether as euro-area Member
States would pool credit risk for some or all of their public debt, implying a
risk of moral hazard. Moral hazard inherent in common issuance arises since the
credit risk stemming from individual lack of fiscal discipline would be shared
by all participants.

As the issuance of Stability Bonds may
weaken market discipline, substantial changes in the framework for economic
governance in the euro area would be required. Additional
safeguards to assure sustainable public finances would be warranted. These
safeguards would need to focus not only on budgetary discipline but also on
economic competitiveness (see Section 3). While the adoption of the new
economic governance package already provides a significant safeguard to be
further reinforced by new regulations based on Article 136[9], there may be a need to go
still further in the context of Stability Bonds – notably if a pooling of
credit risk was to be involved. If Stability Bonds were to be seen as a means
to circumvent market discipline, their acceptability among Member States and investors
would be put in doubt.

While prudent fiscal policy in good times
and a swift correction of any deviation from that path are the core of
responsible, stability-orinetd policy making, experience has shown that broader
macroeconomic imbalances, including competitiveness losses, can have a very
detrimental effect on public finances. Therefore, the stronger policy
coordination required by the introduction of the Stability Bonds must apply
also to avoiding and correcting harmful macroeconomic imbalances.

Ensuring high credit quality and that
all Member States benefit from Stability Bonds

Stability Bonds would need to have high
credit quality to be accepted by investors. Stability
Bonds should be designed and issued such that investors consider them a very
safe investment. Consequently, the acceptance and success of Stability Bonds
would greatly benefit from the highest rating possible. An inferior rating could
have a negative impact on its pricing (higher yield than otherwise) and on
investors' willingness to absorb sufficiently large amounts of issuance. This
would particularly be the case if Member States' national AAA issuance would
continue and thereby co-exist and compete with Stability Bonds. High credit
quality would also be needed to establish Stability Bonds as an international
benchmark and to underpin the development and efficient functioning of related
futures and options markets.[10]
In this context, the construction of Stability Bonds would need to be
sufficiently transparent to allow investors to price the underlying guarantees.
Otherwise, there is a risk that investors would be sceptical of the new
instrument and yields would be considerably higher than the present yields for the
more credit-worthy Member States.

Achieving a high credit quality will
also be important to ensure the acceptance of Stability Bonds by all euro-area
Member States. One key issue is how risks and gains
are distributed across Member States. In some forms, Stability Bonds would mean
that Member States with a currently below-average credit standing could obtain
lower financing costs, while Member States that already enjoy a high credit
rating may even incur net losses, if the effect of the pooling of risk
dominated the positive liquidity effects. Accordingly, support for Stability
Bonds among those Member States already enjoying AAA ratings would require an
assurance of a correspondingly high credit quality for the new instrument so
that the financing costs of their debt would not increase. As explained, this
again would rest on a successful reduction of moral hazard. The acceptability
of Stability Bonds might be further assured by a mechanism to redistribute some
of the funding advantages between the higher-and lower-rated Member States (see
Box 2).

The credit rating for Stability Bonds
would primarily depend on the credit quality of the participating Member States
and the underlying guarantee structure[11].

– With several (not joint) guarantees, each
guaranteeing Member State would be liable for its share of liabilities under
the Stability Bond according to a specific contribution key[12]. Provided that Member States
would continue to obtain specific ratings, a downgrade of a large Member State
would be very likely to result in a corresponding downgrade of the Stability
Bond, although this would not necessarily have an impact on the rating of the
other Member States. In present circumstances with only six AAA euro-area
Member States, a Stability Bond with this guarantee structure would most likely
not be assigned an AAA credit rating and could even be rated equivalently with
the lowest-rated Member State, unless supported by credit enhancement.

– With several (not joint) guarantees enhanced by seniority and
collateral, each guaranteeing Member State would again remain liable
for its own share of Stability Bond issuance. However, to ensure that Stability
Bonds would always be repaid, even in case of default, a number of credit
enhancements could be considered by the Member States. First, senior status could
be applied to Stability Bond issuance. Second, Stability Bonds could be
partially collateralised (e.g. using cash, gold, shares of public companies
etc.). Third, specific revenue streams could be earmarked to cover debt
servicing costs related to Stability Bonds. The result would be that the Stability
Bonds would achieve an AAA rating, although the ratings on the national bonds
of less credit-worthy Member States would be likely to experience a relative deterioration.

– With joint and several guarantees, each guaranteeing
Member State would be liable not only for its own share of Stability Bond
issuance but also for the share of any other Member State failing to honour its
obligations[13].
Even under this guarantee structure, it cannot be completely excluded that the
rating of the Stability Bonds could be affected if a limited number of AAA-rated
Member States would be required to guarantee very large liabilities of other lower-rated
Member States. There is also a risk that in an extreme situation a cascade of
rating downgrades could be set in motion, e.g. a downgrading of a larger
AAA-rated Member State could result in a downgrading of the Stability Bond,
which could in turn feedback negatively to the credit ratings of the other
participating Member States. Accordingly, appropriate safeguards would be
essential to assure budgetary discipline among the participating Member States
via a strong economic governance framework (and possibly seniority of Stability
Bonds over national bonds under an option where these would continue to exist).

Box 2: Possible redistribution of funding advantages between Member
States

The risk of moral hazard associated with Stability Bond issuance
with joint guarantees might be addressed by a mechanism to redistribute some of
the funding advantages of Stability Bond issuance between the higher- and
lower-rated Member States. Such a mechanism could make the issuance of
Stability Bonds into a win-win proposition for all euro-area Member States. A stylised
example using two Member States can be used to demonstrate:

The government debt of both Member
States amounts to about EUR 2 billion, but Member State A pays a yield of
2%, while Member State B pays a yield of 5% on national issuance with 5-year
maturity. Stability Bond issuance would finance both Member States fully, with
maturity of 5 years and an interest rate of 2%). The distribution of Stability
Bond issuance would be 50% for each Member State.

Part of the funding advantage that Member State B would enjoy from
Stability Bond issuance could be redistributed to Member State A. For example,
a 100bps discount for Member State A could be financed from the 300 bps premium
for Member State B. Accordingly, the Stability Bond could fund Member State A at
a yield of 1% and fund Member State B at a yield of 3%. Both Member States
would have lower funding costs relative to national issuance.

Needless to say, the mechanism for internal distribution of the
benefits from Stability Issuance would need to be formulated but would be
linked to relative budgetary performance in the context of the euro-area
economic governance framework.

1.3.2.
Ensuring consistency with the EU Treaty

Consistency with the EU Treaty would be
essential to ensure the successful introduction of the Stability Bond. Firstly, Stability Bonds must not be in breach of the Treaty
prohibition on the “bailing out” of Member States. The compatibility of Stability
Bonds with the current Treaty framework depends on the specific form chosen.
Some options could require changes in the relevant provisions of the Treaty.
Article 125 of the Treaty on the functioning of the European Union (TFEU)
prohibits Member States from assuming liabilities of another Member State.

Issuance of Stability Bonds under joint
and several guarantees would a priori lead to a situation where the prohibition
on bailing out would be breached. In such a
situation, a Member State would indeed be held liable irrespective of its
'regular' contributing key, should another Member State be unable to honour its
financial commitments. In this case, an amendment to the Treaty would be
necessary. This could be made under the simplified procedure if a euro area
common debt management office were constructed under an inter-governmental
framework, but would most likely require the use of the ordinary procedure if
it were placed directly under EU law since it would extend the competences of
the EU. Unless a specific basis is established in the Treaty, an EU-law based
approach would probably require the use of Article 352 TFEU, which implies
a unanimous vote of the Council and the consent of the European Parliament. The
issuance of Stability Bonds and the tighter economic and fiscal coordination
needed for ensuring its success would also most likely require significant
changes to national law in a number of Member States[14].

Issuance of Stability Bonds under
several but not joint guarantees would be possible within the existing Treaty
provisions. For example, increasing
substantially the authorised lending volume of the ESM and changing the lending
conditions with a view to allowing it to on-lend the amounts borrowed on the
markets to all euro-area Member States could be constructed in a way compatible
with Article 125 TFEU, provided the pro-rata nature of the contributing key
attached to the ESM remains unchanged. The same reasoning would apply to
issuances of a possible common debt management office, whose liabilities would
remain limited to a strictly pro-rata basis.

The Treaty would also need to be changed
if a significantly more intrusive euro-area economic governance framework was
to be envisaged. Depending on the specific
characteristics of Stability Bonds, fiscal and economic governance and
surveillance in participating Member States would have to be reinforced to
avoid the emergence of moral hazard. Further qualitative changes in governance
beyond the proposals included in the 23 November package will probably
require changes in the Treaty. Section 3 discusses such options of reinforced
fiscal governance in more depth.

2.
Options for issuance of Stability Bonds

Many possible options for issuance of
Stability Bonds have been proposed, particularly since the onset of the
euro-area sovereign crisis. However, these options
can be generally categorised under three broad approaches, based on the
degree of substitution of national issuance (full or partial) and the nature of
the underlying guarantee (joint and several or several) implied. The three broad
approaches are[15]:

(1)
the full substitution of Stability Bond issuance
for national issuance, with joint and several guarantees;

(2)
the partial substitution of Stability Bond
issuance for national issuance, with joint and several guarantees; and

(3)
the partial substitution of Stability Bond
issuance for national issuance, with several but not joint guarantees.

In this section, each of the three
approaches is assessed in terms of the benefits and preconditions outlined in
Section 1.

2.1.
Approach No. 1: Full substitution of Stability
Bond issuance for national issuance, with joint and several guarantees

Under this approach, euro-area
government financing would be fully covered by the issuance of Stability Bonds
with national issuance discontinued. While Member
States could issue Stability Bonds on a decentralised basis via a coordinated
procedure, a more efficient arrangement would imply the creation of a single
euro-area debt agency[16].
This centralised agency would issue Stability Bonds in the market and
distribute the proceeds to Member States based on their respective financing
needs. On the same basis, the agency would service Stability Bonds by gathering
interest and principal payments from the Member States. The Stability Bonds
would be issued under joint and several guarantees provided by all euro-area
Member States, implying a pooling of their credit risk. Given the
joint-and-several nature of guarantees, the credit rating of the larger
euro-area Member States would most likely dominate in determining the Stability
Bond rating, suggesting that a Stability Bond issued today could be expected to
have a high credit rating. Nevertheless, the design of the cross-guarantees
embedded in Stability Bonds and the implications for credit rating and yields
would need to be more thoroughly analysed.

This approach would be most effective in
delivering the benefits of Stability Bond issuance. The full substitution of Stability Bond issuance for national
issuance would assure full refinancing for all Member States irrespective of
the condition of their national public finances. In this way, the severe
liquidity constraints currently experienced by some Member States could be
overcome and the recurrence of such constraints would be avoided in the future.
This approach would also create a very large and homogenous market for Stability
Bonds, with important advantages in terms of liquidity and reduced liquidity risk
premia. The new Stability Bonds would provide a common euro-area benchmark bond
and so offer a more efficient reference framework for the pricing of risk
throughout the euro-area financial system. By assuring high quality
government-related collateral for financial institutions in all Member States,
it would maximise the benefits of common issuance in improving the resilience
of the euro-area financial system and in improving monetary-policy
transmission. The Stability Bond under this approach would also provide the
global financial system with a second safe-haven market of a size and liquidity
comparable with the US Treasury market and so would be most effective in
promoting the international role of the euro.

At the same time, this approach would
involve the greatest risk of moral hazard. Member
States could effectively free ride on the discipline of other Member States,
without any implications for their financing costs. Accordingly, this approach would
need to be accompanied by a very robust framework for delivering budgetary discipline,
economic competitiveness and reduction of macroeconomic imbalances at the
national level. Such a framework would require a significant further step in
economic, financial and political integration compared with the present
situation. Without this framework, however, it is unlikely that this ambitious
approach to Stability Bond issuance would result in an outcome that would be
acceptable to Member States and investors. Given the joint-and-several
guarantees for the Stability Bond and the robustness required in the underlying
framework for budgetary discipline and economic competitiveness, this approach
to Stability Bond issuance would almost certainly require Treaty changes.

Under this approach, the perimeter of
government debt to be issued via Stability Bonds would need to be defined. In several Member States, bonds are not only issued by central
governments but also by regional or municipal governments[17]. In principle, one might opt
for including sub-national issuance. The obvious advantage would be that the
potential benefits in terms of market stability, liquidity and integration
would be broadened. It would also be consistent with the EU approach to
budgetary surveillance, which covers the entire general government debt and
deficits. On the other hand, pooling issuance only of central governments might
deliver a more transparent and secure arrangement. Central government data are typically
more easily accessed, which is not always the case for local authorities.
Moreover, the issuance would cover only deficits fully controlled by central
governments. From a purely market point of view, such Stability Bonds would
replace only widely known central government bonds, which would facilitate the
assessment and valuation of the new Stability Bonds[18].

The process for phasing-in under this
approach could be organised in different ways depending on the desired pace of
introduction. Under an
accelerated phasing-in, new issuances would be entirely in the form of Stability
Bonds and outstanding government bonds could be converted into new Stability
Bonds, i.e. in form of a switch of a certain amount of national government
bonds in exchange for new Stability Bonds. The main advantage of this option
would be the almost immediate creation of a liquid market with a complete
benchmark yield curve. The buy-back of legacy bonds could also alleviate the
current acute financing problems of the Member States with high debt and high
interest rates. However, the operation may be complicated and would require
careful calibration of the conversion rate to minimise market disruption. An
alternative would be a more gradual scheme, i.e. full, or even only partial,
new gross issuance for each Member States in Stability Bonds while outstanding
euro-area government bonds would remain in circulation on the secondary market.
This would allow the market to gradually become accustomed to the new
instrument and develop analytical/pricing tools, thereby posing less risk of
market disruption. However, in this variant, building a complete Stability Bond
market would take several years (depending on maturities of outstanding bonds),
delaying possible benefits. As for the outstanding legacy bonds, this segment
would be gradually declining, as being replaced by Stability Bonds and newly
issued national bonds. Hence, the overall liquidity of that segment would
decline over time and accordingly, the liquidity premium on legacy bonds might
gradually rise.

Due to the need for changes to the Treaty the
implementation of this approach might take a considerable amount of time.

2.2.
Approach No. 2: Partial substitution of national
issuance with Stability Bond issuance with joint and several guarantees

Under this approach, Stability Bond
issuance would be underpinned by joint and several guarantees, but would
replace only a limited portion of national issuance.
The portion of issuance not in Stability Bonds would remain under respective
national guarantees. This approach to common issuance has become known as the
“blue-red approach”[19].
Accordingly, the euro area sovereign bond market would consist of two distinct
parts:

– Stability Bonds (or "blue bonds"): The issuance of Stability Bonds would
occur only up to certain predefined limits and thereby not necessarily covering
the full refinancing needs of all Member States. These bonds would benefit from
a joint-and-several guarantee and would imply a uniform refinancing rate for
all Member States[20].

– National government bonds ("red
bonds"). The remainder of the issuance required to finance Member State
budgets would be issued at the national level under national guarantees. In
consequence, national bonds would, at least de facto, be junior to Stability
Bonds because of the latter's coverage by joint-and-several guarantees[21]. The scale of national
issuance by each Member State would depend on the agreed scale of common
issuance of Stability Bonds and its overall refinancing needs. Depending on the
size of these residual national bond markets and issuances and the country's
credit quality, these national bonds would have country-specific liquidity and
credit features and accordingly different market yields, also since most
sovereign credit risk would be concentrated in the national bonds, amplifying
the credit risk[22].
The intensified market pressures on national issuance would provide market
discipline.

A key issue in this approach would be the
specific criteria for determining the relative proportions of Stability Bond
and national issuance. The main options would be:

– A simple rule-based system: For example,
each Member State could be entitled to an amount of Stability Bonds equal to a
specified percentage of its GDP, perhaps reflecting the Treaty criterion of
60%. An important dimension to consider is how much risk would be concentrated
on the national (and junior) part, this being dependent on the size of the
common issuance (the higher the share of Stability Bond issuance, the more risk
is concentrated on the residual national issuance). To avoid excessive credit
risk in national issuance, while still delivering liquidity benefits through
common issuance, it might be appropriate to set the ceiling at a more prudent
level.

– A more flexible system linked to policy compliance: The maximum amount of a Member State's Stability Bond issuance
could be fixed as above, but the ceiling at any point in time would be linked
to the Member State's compliance with rules and recommendations under the euro-area
governance framework. Non-compliance could be sanctioned by a (possibly automatic)
lowering of the respective Stability Bond debt ceiling for the Member State
concerned (see also Section 3). This system would also serve as a
quasi-automatic stabilizer of the credit quality of the Stability Bonds, as the
respective share of fiscally underperforming Member States would be reduced.

The credibility of the ceiling for the Stability
Bond issuance would be a key consideration. Once
the blue bond allocation is exhausted, the financing costs for the Member State
could increase substantially. This could result in political pressures to
increase the ceiling. Unless there are strong safeguards against such
pressures, anticipation of a "soft" ceiling could largely eliminate
the disciplining effects of the blue-red approach. Therefore, irrespective of
the criteria established for determining the ceiling for Stability Bond
issuance, it would be essential that that this ceiling should be maintained and
not adjusted on an arbitrary basis, e.g. in response to political pressure.

This approach to Stability Bond issuance
is less ambitious than the full-issuance approach above and so delivers less in
terms of economic and financial benefits. Due to
their seniority over the national bonds and guarantee structure, the Stability
Bonds would pose a very low credit risk, the latter reflected in high credit
ratings (i.e. AAA). The yield on the Stability Bonds would therefore, be
comparable with yields on existing AAA government bond in the euro area. In
consequence, there would be corresponding benefits in terms of euro-area
financial stability, monetary policy transmission and the international role of
the euro, although these would be less than under the more ambitious approach
of full substitution of Stability Bond issuance for national issuance. As the
build-up phase in Stability Bond issuance toward the agreed ceiling would most
likely take several years, all Member States could, during the start-up phase,
have very broad access to financial markets via Stability Bonds. This would
overcome possible liquidity constraints faced by some Member States but for
that period give rise to the same moral hazard implications as discussed in
Section 2.1 under full issuance. Given that a return to national issuance
for these latter Member States would be required when the Stability Bond
ceiling would be reached, they would need to provide reassurance that during
this time they would undertake the budgetary adjustments and structural reforms
necessary to reassure investors and so maintain access to markets after the
introductory period. The yields on the newly issued national bonds would,
however, rise due to their junior status. Ultimately, assuming a reasonably
high proportion of Stability Bond issuance has been reached, the market would
be expected to be liquid, but less liquid than if all issuances were in Stability
Bonds as the residual national bonds would also hold a certain market share.

On the other hand, the preconditions for
Stability Bond issuance would be somewhat less binding under this approach. Establishing a ceiling for Stability Bond issuance would help to
reduce moral hazard by maintaining a degree of market discipline through the
residual national issuance. However, the relationship between moral hazard,
market discipline, and contagion risk in determining the appropriate Stability
Bond ceiling is not straightforward. A relatively low Stability Bond ceiling
(implying a large amount of residual national issuance) would limit moral
hazard but could leave Member States with existing high debt levels vulnerable
to the risk of catastrophic default on their national issuance. Such a
catastrophic default would carry contagion risk for the euro area as a whole. A
relatively high Stability Bond ceiling (implying a small amount of residual
national issuance) would imply a greater risk of moral hazard but would still
allow the possibility of default in a Member State with less catastrophic
effects and less contagion risk for euro area as a whole. A robust framework
for maintaining fiscal discipline and economic competitiveness at national
level would still be required to underpin the Stability Bond issuance, although
the market discipline provided via the retention of national issuance might
imply a less dramatic transfer of sovereignty than under the approach of full Stability
Bond issuance. Meanwhile, the choice of ceiling would also determine the likely
credit quality of the Stability Bond. A relatively low ceiling would
underpin the credit quality of Stability Bonds by limiting the amount of debt
covered by the stronger joint and several guarantees[23]. The joint-and-several
guarantee for the Stability Bond would almost certainly require Treaty changes.

The process for phasing-in under this
approach could again be organised in different ways depending on the desired
pace of introduction. Under an accelerated phasing-in,
a certain share of outstanding euro-area government bonds would be replaced by Stability
Bonds at a pre-specified date using pre-specified factors. This would rapidly
establish a critical mass of outstanding Stability Bonds and a sufficiently
liquid market with a complete benchmark yield curve.
However, it could imply that most Member States reach the ceilings at the
moment of the switch and that they would have to continue tapping capital
markets with national bonds. Under current market conditions, this might
constitute a drawback for some Member States. Under a more gradual phasing-in,
all (or almost all) new gross issuance for Member States would be in Stability
Bonds until the Stability Bond issuance target ceiling is reached. Since for
several years only (or nearly only) Stability Bonds would be issued, this
approach would help to ease market pressure and give vulnerable Member States
time for the reforms to take effect. However, specific challenges emerge for
the transition period, as highly indebted countries typically have larger and
more frequent rollovers. Unless other arrangements are agreed, their debt
replacement with Stability Bonds up to the ceiling will be more rapid than the
average, while for countries with debt below the ceiling, it would take longer.
In consequence, the individual risk, which a possible
"joint-and-several" guarantee is covering, would be skewed to the
higher side in the transition phase, while on the other side the liquidity
effect, which should compensate the AAA countries, would still be small. This
specificity may need to be reflected in the governance arrangements. For
example, an alternative could be to set annual predefined ceilings, rising
slowly from zero to the desired long-term value.

Due to the need for changes to the Treaty,
the implementation of this approach might also take, as for Approach No 1, some
considerable time, although the lesser degree of necessary changes to economic
and fiscal governance, due to the partial reliance of markets for signalling
and disciplining, might make the implementation process less complex and
time-consuming.

Box 3: Debt redemption pact and safe bonds

As a specific example of the partial issuance approach, the German
Council of Economic Experts (GCEE) presented in their Annual Report 2011/12[24] a proposal for safe bonds that
is a part of a euro-area wide debt reduction strategy aimed at bringing the
level of government indebtedness back below the 60% ceiling as put in the
Maastricht Treaty.

One of the pillars of the strategy is a so-called debt redemption
fund. The redemption fund would pool government debt exceeding 60% of
individual countries' GDP of euro area Member States. It would be based on
joint liability. Each participating country would, under a defined a
consolidation path, be obliged to autonomously redeem the transferred debt over
a period of 20 to 25 years. The joint liability during the repayment phase
means that safe bonds would thereby be created. In practice, the redemption
fund would issue safe bonds and the proceeds would be used by participating
countries to cover their pre-agreed current financing needs for the redemption
of outstanding bonds and new borrowing. Therefore, the debt transfer would
occur gradually over around five years. Member States with debt above 60% of
GDP would therefore not have to seek financing on the market during the roll-in
phase as long as the pre-agreed debt reduction path was adhered to. After the
roll-in phase, the outstanding debt levels in the euro area would comprise: (i) national
debt up to 60% of a country's GDP, and (ii) debt transferred to the
redemption fund amounting to the remainder of the debt at the time of transfer.
Open questions remain, for example on the fund's risk, and the impact on the de
facto seniority from collateralisation of the fund's bonds.

The GCEE debt redemption pact combines (temporary) common issuance
and strict rules on fiscal adjustment. They do not constitute a proposal for Stability
Bonds in the meaning of this Green Paper, in the sense that common issuance
would be temporary and used only for Member States with public debt ratios
above 60% of GDP. Instead, the GCEE proposes to introduce a temporary financing
tool that would give all euro-area Member States time, and financial breathing
space, to bring their debt below 60% of GDP. Once this goal is reached the fund
and safe bonds will be automatically liquidated. Therefore, safe bonds are a
crisis tool rather than a way of permanent integration of the euro-area
government bond markets. Even though temporary, the debt redemption pact could
contribute to the resolution of the current debt overhang problem.

2.3.
Approach No. 3: Partial substitution of national
issuance with Stability Bond issuance with several but not joint guarantees

Under this approach, Stability Bonds
would again substitute only partially for national issuance and would be
underpinned by pro-rata guarantees of euro-area Member States[25]. This approach differs from Approach No. 2 insofar as Member
States would retain liability for their respective share of Stability Bond
issuance as well as for their national issuance. However, issues relating to
the split between Stability Bond and national issuance, including the choice of
ceiling for Stability Bond issuance, would be largely the same.

This approach to the Stability Bond would
deliver fewer of the benefits of common issuance but would also require fewer
preconditions to be met. Due to the several, but
not joint, guarantee, moral hazard would be mitigated. Member States could not
issue benefiting from a possibly higher credit quality of other Member States.
In addition, the continued issuance of national bonds would expose Member
States to market scrutiny and market judgement that would be an additional,
possibly and at times, strong deterrent to irresponsible fiscal behaviour.
While this approach would be of more limited use in fostering financial market
efficiency and stability, it would be more easily and more rapidly deployable.
Given the several but not joint guarantees, Member States subject to high
market risk premia would benefit considerably less from the creditworthiness of
low-yield Member States than in Approach No. 2 and particularly than in
Approach No. 1. In that sense, the possible contribution of Approach
No. 3 to mitigating a sovereign debt crisis in the euro area and its
possible implications on the financial sector would be much more limited.
However, given the possibly much faster implementation time of this approach,
it could, unlike the other two approaches possibly help addressing the current
sovereign debt crisis.

The key issue with this approach would
be the nature of the guarantee underpinning the Stability Bond. In the absence of any credit enhancement, the credit quality of a Stability
Bond underpinned by several but not joint guarantees would at best be the
(weighted) average of the credit qualities of the euro-area Member States. It
could even be determined by the credit quality of the lowest-rated Member State,
unless they enjoy credible seniority over national issuance in the case of all
Member States (see below). This could reduce the acceptance of the instrument
among investors and among the higher-rated Member States and undermine the
benefits of Stability Bonds, notably their resilience in times of financial
stress.

In order to increase acceptance of the Stability
Bond under this approach, the quality of the underlying
guarantees could be enhanced. Member States could provide seniority to the
debt servicing of Stability Bonds. Furthermore, Member States could provide
collateral, such as cash, gold reserves which are largely in excess of needs in
most EU countries, as well as earmarking specific tax receipts to servicing of Stability
Bonds. More than for approach no. 2, where the common part is backed by
joint and several guarantees, the feasibility of this option relies on the
seniority status of the common issuer and on a prudent limit for the common
issuance. This points to the need for careful analysis of the implications of
this option for current bonds in circulation, where some negative pledge
clauses may exist, and the identification of appropriate solutions.

While under normal conditions, the total
cost of debt for a country should remain constant or fall, the marginal cost of
the debt would rise. This should help in containing
moral hazard and prompting budgetary discipline, even in the absence of any
particular form of enhanced governance or fiscal surveillance. The Stability
Bond would thereby provide a link and reinforce the effectiveness of the newly
established governance package, if the amounts to be funded through common
issuance are determined in close connection with fiscal targets established in
the Stability programmes and create strong incentives to rapidly reduce overall
debt levels[26].
It would also eliminate the need for a Treaty change in this regard. However,
maintaining the credit quality of the Stability Bond would most likely require
secondary legislation to establish the seniority status of the Stability Bond.

The alternatives in the treatment of
legacy bonds, as well as their respective advantages and disadvantages, would
be similar to the ones described under Approach No. 2.

This option could be implemented
relatively quickly. This option could be pursued
without requiring changes to the EU Treaty, while secondary legislation may be
helpful to strengthen the seniority principle. Furthermore, substitution of
national by Stability Bonds would only be partial.

2.3.1.
Combining the approaches

As the scope, ambition and required
implementation time vary across the three approaches, they could also be
combined. Approach No. 1 can be considered the
most ambitious approach, which would deliver the highest results in market
integration and strengthening stability but it might require considerable time for
implementation. Conversely, Approach No. 3, with its different scope and
guarantee structure, seems to be more easily ready for a more rapid deployment.
Hence, there is a certain trade-off between ambition of the features and scope
of the Stability Bond and the possible speed of implementation. To overcome
this trade-off, the various options could be combined as sequential steps in a
process of gradual implementation: a relatively early introduction based on a
partial approach and a several guarantee structure, combined with a roadmap
towards further development of this instrument and the related stronger
governance. Such an upfront political roadmap could help ensuring the market
acceptance of Stability Bonds from the outset.

2.3.2.
Impact on non-euro area Member States of the EU
and third countries

Participation in the Stability Bond
framework is usually conceived for the Member States of the euro area[27]. This is a due to the normal desire of Member States to issue debt and
maintain markets in their own currency and of the fact that E-bonds might be
part of a framework of a higher degree of economic and political integration.
However, these Member States would nevertheless be affected by the introduction
of Stability Bonds, accompanied by a reinforced framework of economic
governance. Financial stability across the euro area fostered by Stability
Bonds would also directly and substantially stabilise financial markets and
institutions in these countries. The same would apply for any third country, to
the extent of its economic and financial linkages with the euro area. On the
other hand, the creation, by Stability Bonds, of a very large and sound market
for safe assets might add to competition between financial markets for
investors' interest.

Table 1: Overview over the three main options

|| (Option 1) || (Option 2) || (Option 3)

Main features || || ||

– Degree of substitution of national issuance by Stability Bonds || Full || Partial || Partial

– Guarantee structure || Joint and several || Joint and several || Several (not joint) with enhancements

Main effects || || ||

– on average funding costs 1/ for Stability Bond as a whole 2/ across countries || 1/ Medium positive effect from very large liquidity compensated by strong moral hazard. 2/ Strong shift of benefits from higher to lower rated countries || 1/ Medium positive effect, from medium liquidity and limited moral hazard 2/ Smaller shift of benefits from higher to lower rated countries. Some market pressure on MS with high level of debt and subprime credit ratings || 1/ Medium positive effect, lower liquidity effect and sounder policies prompted by enhanced market discipline 2/ no impact across country. Stronger market pressure on MS with high level of debt and subprime credit ratings

– on possible moral hazard (without reinforced governance) || High || Medium, but strong market incentives for fiscal discipline || Low, strong market incentives for fiscal discipline

– on financial integration in Europe || High || Medium || Medium

– on global attractiveness of EU financial markets || High || Medium || Medium

– on financial market stability || High || High, but some challenges in case of unsustainable levels of national issuance || Low, but it may help to deal with the current crisis thanks to its rapid implementation.

Legal considerations || Probably Treaty change || Probably Treaty change || No Treaty changes required. Secondary legislation may be helpful.

Necessary minimum implementation time || Long || Medium to long || Short

3.
Fiscal framework for Stability Bonds
3.1.
Background

The fiscal surveillance framework has
already been strengthened with the recent reform of the SGP including new
enforcement mechanisms. Moreover, it should be
further reinforced in the near term, especially for euro-area Member States under
EDP and/or requesting or receiving financial assistance, in line with the recent
conclusions of the euro-area Heads of States and Governments and the Commission
proposal for two new Regulations based on Article 136:

– the proposal for a Regulation on common provisions for monitoring
and assessing draft budgetary plans and ensuring the correction of excessive
deficit in the euro area Member States pursues the triple aim of
(a) complementing the European semester with a common budgetary timeline
aiming at better synchronizing the key steps in the preparation of national
budgets; (b) complementing the multilateral surveillance system of
budgetary policies (the preventive arm of the SGP) with additional monitoring
requirements in order to ensure that EU policy recommendations in the budgetary
area are appropriately integrated in the national budgetary preparations and
(c) complementing the procedure for correction of a Member State's
excessive deficit (the corrective arm of the SGP) by a closer monitoring of
budgetary policies of Member States in excessive deficit procedure in order to
secure a timely durable correction of excessive deficits;

– the proposal for a Regulation on enhanced surveillance ensures that
a euro area Member State should be subject to enhanced surveillance when it is
experiencing - or at risk of experiencing - severe financial disturbance, with
a view to ensuring its swift return to a normal situation and to protecting the
other euro area Member States against possible negative spill over effects.

These two new Regulations together with the
profound changes stemming from the reform of the SGP constitute a solid
foundation for enhanced coordination of budgetary policy of the euro area
Member States.

Still, Stability Bonds create risks of
moral hazard and require a further strengthening of the framework, depending on
the chosen option. Three dimensions of such a
strengthened framework may be identified:

– Increased surveillance and intrusiveness in the design and
implementation of national fiscal policies would be warranted beyond the recent
proposals. Further, the servicing of Stability Bonds would be fully assured.

– At the same time, the very existence of Stability Bonds could
fundamentally alter budgetary processes, notably via the allocation
mechanisms, and offer a tool to effectively enforce a rule-based framework for
fiscal policies.

– Fiscal conditions could be demanded for entering the system of Stability
Bonds, with the effect of reinforcing the credibility of both current
adjustment plans and at cruising speed.

3.2.
Increased surveillance and intrusiveness in
national fiscal policies

The recent and forthcoming reforms of
surveillance create a sound basis to limit these risks, but more would be
needed. Such strengthening of the framework could
apply to EU surveillance and to national budgetary frameworks.

In line with currently discussed
changes, this would entail more thorough examination of draft budgets, not only
for fiscally distressed countries but for all participating Member States. EU approval of budgets could be needed for participating Member States
under certain circumstances such as high indebtedness or deficit levels.
Moreover, a much stronger monitoring framework of budgetary execution would be
required. This could include including regular reporting at common budgetary
'rendezvous', the development of alert mechanisms based on fiscal scoreboards,
and the actual possibility of correcting slippages during execution – for
instance by explicitly planning ex ante budgetary reserves and conditioning the
entry into force of costly new measures on on-track execution.

National fiscal frameworks will be
strengthened in the relatively near term by the
implantation of the Directive on fiscal frameworks (which could in fact be
accelerated). Furthermore, there are ongoing discussions to go further, inter
alia by the introduction of rules translating the SGP framework in national
legislation, preferably at constitutional level, and with adequate enforcement
mechanisms. Other possible key reinforcements of national frameworks include
the adoption of binding medium-term frameworks, independent bodies assessing
the underlying assumptions of national budgets and effective coordinating
mechanisms between levels of public administration. As regards the latter
point, the pooling of debt at European level may give additional reason to
bring closer the debt management of sub-sectors of public administration.

National frameworks also have an
important role to play in supporting surveillance at EU level. For example, common timelines in the preparation of budgets would
facilitate EU surveillance (and may in fact be necessary to devise the
allocation for Stability Bonds in practice). Similarly, a proper monitoring of
budget execution at EU level hinges on sound national arrangements to that aim,
which could call for the adoption of common standards of control and
disclosure.

A system would have to be put in place
that credibly ensures the full debt service of each Member State benefiting
from the issuance of Stability Bonds. This entails
that the servicing of Stability Bonds, or more specifically the payment of
interest on common issuance, should not come under any circumstances into
question. One option to this end would be to grant extensive intrusive power at
EU level in cases of severe financial distress, including the possibility to
put the failing MS under some form of 'administration'. Another option, as
already mentioned in the previous section, that would perhaps less infringe on
national sovereignty would be to introduce a clause for participating countries
on seniority of debt service in the Stability Bonds system over any other
spending in the national budgets. Such rules would need to have stringent legal
force, presumably at constitutional level. In addition and in accordance to
that, obligations towards the Stability Bonds system would have to be senior to
(remaining) new national emissions if any.

3.3.
Stability Bonds as a component of an improved
fiscal framework

While Stability Bonds create risks of
moral hazard, they are also likely to change at the root the conditions in
which budgetary policies are formulated and implemented. This is notably because European guidance on national budget
policies would be translated into tangible figures by the very process of
setting borrowing allocations to participating Member States. Indeed, the
functioning of Stability Bonds would under all discussed options require
devising ex ante ceilings for national borrowing that would then frame
or at least affect national budgets, especially in case of wide-reaching
options (i.e. Approach No 1 above) where Stability Bonds would be expected
to cover all or the bulk of new financing needs of participating countries. In
this perspective, Stability Bonds may be regarded not only as a potential source
of moral hazard, but also as a driver of better coordination of budgetary
policies through the effective enforcement of a rule-based framework.

If Stability Bonds would provide all or
the bulk of government finance (i.e. Approach No. 1) clear principles
would have to guide the framework for allocations under the Stability Bond
scheme:

(1)
The maximum allocations would have to be
based on sufficiently sound fiscal rules, with the
framework under the SGP offering a natural basis. The rules would thereby provide
strong incentives for responsible fiscal behaviour.

(2)
These guidelines would have to address the
degree of flexibility to deal with unexpected
developments and to minimise the risk of pro-cyclical policies. A key question
would be whether fiscal flexibility to respond to shocks, either
country-specific or at the level of the euro area, would be provided by
additional issuance of Stability Bonds or would have to rely on national
issuance (provided they remain possible). The more flexibility is allowed within
the system, the higher the need for constraining mechanisms (such as control
accounts) to ensure that flexibility is kept within agreed limits and avoid
'debt creeping'.

(3)
The rules should likely also incorporate some
form of 'graduated response' to unsound fiscal developments. This graduation could take the form of reinforced surveillance,
intrusiveness into national fiscal policies, as envisaged above.

In addition, financial incentives for
sound fiscal policies could be built into the system. While yields of Stability Bonds would be market-based, funding
costs might be differentiated across Member States depending on their fiscal
positions or fiscal policies, or their market creditworthiness, as reflected by
the risk-premium of national issuances over common issuances. This would
provide an incentive for sound fiscal policies within the system and would
mimic market discipline though in a smoother, more consistent fashion than
markets. Such an incentive, which would automatically exist under the 'several
guarantee' option, could be further enhanced with 'punitive' rates in case of
slippages from plans.

3.4.
Fiscal conditions for entering the system

In order to implement the vision of Stability
Bonds as "stability bonds" one might also set macro-economic and fiscal
conditions for Member States in order to enter and remain in the system. For example, Member States might be denied access to Stability
Bonds if they have not respected their commitments under the SGP or under a
reinforced fiscal framework. Alternatively, Member
States in breach of their fiscal targets might have to provide (additional)
collateral for new Stability Bond issuance or might be subject to an interest
surcharge. Access could also be limited as a function of the degree of
non-compliance, i.e. a deviation of the general government budget by each
percentage point of GDP might reduce the right to issue Stability Bonds by a
certain amount of percentage points of GDP.

A number of benefits could be expected from
this approach:

– First, to the extent that they wish to be included in the Stability
Bonds system, Member States would have additional incentives to fully implement
the consolidation and reform efforts they have already engaged into, in a
fashion not unlike the convergence efforts undertaken in order to adopt the
euro.

– Second, financial markets and societies at large would consider
consolidation plans as more credible given the prospect for Stability Bonds.
Thereby, the prospect of joining Stability Bonds could raise confidence already
in the relatively near term. Such renewed confidence could in fact facilitate
fiscal adjustments in some countries.

– Finally, strong fiscal conditions for entry and continued
participation would be instrumental in lowering debt ratios and borrowing needs
before the respective countries participate in the Stability Bonds. In this
manner, risk premia and yields of Stability Bonds could be lowered.

Such an approach would imply that Member
States would need to maintain residual financing possibilities, in case they do
not meet these conditions. Hence, the Stability Bond would not necessarily
replace the entire bond issuance of euro area Member States. One would also
have to designate an institution or body responsible to monitor the compliance
with these entry criteria (for example, but not necessarily, the DMO).

4.
Implementation issues
4.1.1.
Organisational set-up

A number of technical issues would need
to be decided with respect to the organisation of Stability Bond issuance. Most importantly, the institutional structure of funding operations
would need to be determined, i.e. whether a centralised debt management office
(DMO) would be established or whether the essential functions could be carried
out in a decentralised way by national Treasuries and DMOs. As regards the
decentralised approach, issuance would need to be conducted under uniform terms
and procedures and would require a high degree of co-ordination. Whereas
the centralised approach would avoid the coordination of bond issuances, it would
still require the transmission of detailed and reliable information on Member
States financing needs so that the issuances could be planned. With respect to
the design of a central issuance agent, several options are conceivable,
including: (a) the European Commission could serve as DMO, which would
allow speedy introduction of the Stability Bond and allow the instrument to be
used to manage the current crisis; or (b) the EFSF/ESM could be
transformed into a full scale DMO; or (c) a new EU DMO could be created[28], which would require some time
to become operational. The exact administrative cost of the introduction of Stability
Bonds cannot be calculated without all other details being defined in advance.
Their magnitude would also have an impact on the Member States budgets.

An important technical issue would be
how a centralised DMO would on-lend the funds raised to the Member States. In principle, there would be two options, which could also be
combined: (a) on-lending in the form of direct loans, where the Member
State would receive its funding through a loan agreement; and (b) the
direct purchase of all, or the agreed amount of, government bonds from the
Member States by the DMO in the primary market. The second option would allow
the DMO to also buy outstanding government debt in the secondary market, if
needed.

The repayment of bonds would also need
to be organised. The most straightforward way of
doing this would be through transfers by the national authorities to the
issuing agent that would organise the repayment to the bondholders. In order to
ensure that market participants could trust that the servicing of debt would
always be guaranteed and delays of payments would not occur, the DMO would need
to be endowed with a stable and predictable revenue stream. While Member States
would need to guarantee the liabilities of this body, it would need to be
verified whether this would be sufficient or whether additional collateral,
cash buffers might be required. Present national debt management offices are
part of the national fiscal institutions, being backed by the governments'
authority to raise taxes. For a debt management office at supranational level,
there would not be such a direct link to tax revenues, which might reduce the
market's acceptance of the debt instruments to be issued.

Even with Stability Bonds, there would be
a need for Member States' liquidity management. It
might in practice be nearly impossible to design bond issuance in such a way
that it would provide a perfect match of Member States' payment streams. Therefore,
there would, be a need to supplement Stability Bond issuance with day-to-day
liquidity management, which could be left to the national authorities. One
option would be that the Stability Bond issuance would focus on medium-term
funding needs and that the national authorities would manage their payment
profiles through short-term deposits and loans or bills. Irrespective of the
organisational set-up, procedures would need to be developed to coordinate the
funding plans of individual Member States, with a view to develop benchmark
issues and to build a complete benchmark yield curve.

4.1.2.
Relationship with the ESM

The setting up of an agent for joint
issuance of Stability Bonds for euro area Member States might warrant a
clarification of the division of tasks with the European Stability Mechanism. In principle, two main views can be adopted: The ESM might be
considered materially redundant, as joint issuance, coupled with reinforced
fiscal surveillance rules, could assume the role of organising ordinary finance
for Member States' governments as well as exceptional additional finance in
case of serious difficulties of a Member State. However, mixing the roles of
debt management and emergency financing might be suboptimal and lead to a
confusion of roles, a weakening of incentives and governance and an overly
complex single funding institution. For this reason, the ESM could remain as a
separate issuer of debt for the purpose of organising and meeting exceptional
financing needs.

The choice of interaction with the ESM
would also depend on the respective option for Stability Bonds. The ESM could be considered fairly redundant in case of Approach
No. 1 for Stability Bonds. Under this approach, that foresees nearly full
coverage of financing needs by Member States, also exceptional additional
financing needs could be provided. The situation seems much less clear in the
case of Approaches Nos. 2 and 3, under which Member States would continue to
issue national bonds in parallel to joint issuance of Stability Bonds. One
might even contemplate to use the ESM framework for first steps towards
Stability Bonds. As the ESM will be based on several guarantees by Member
States, the gradual introduction of Stability Bonds based on several (but not
joint) guarantee, i.e. based on Approach No. 3, could be encompassed
by ESM financing and issuance that would go beyond the current role of
providing exceptional financial assistance. In principle, joint and several
guarantees could be applied to the ESM at a later stage.

4.1.3.
Legal regime governing issuance

Consideration must also be given to the
appropriate legal regime under which Stability Bonds would be issued. Currently, government bonds are issued under domestic law. For
international bond issuances, English law or, if the US market is targeted, New
York law is often used. An equivalent EU law, under which Stability Bonds could
be issued, does not exist. Although it is common practice to rely on foreign
law for international bond issuances, there may be a problem if all government
debt was covered by UK or US law, because the Anglo-Saxon case-law approach is
different from the legal system in many Member States. The relevant court would
also need to be agreed upon.

4.1.4.
Documentation and market conventions

A decision on funding options, security
characteristics and market conventions would be needed. For an established issuer, auctions would be the preferred option
for issuance. Syndication has the advantage that the financial industry is
involved in marketing the instruments and the pricing of a security is more
predictable. In addition, typically larger amounts may be placed via
syndication as it reaches also retail-investors. In addition, various security
characteristics and market conventions would need to be determined. The most
important ones of these are addressed in Annex 4.

4.1.5.
Accounting issues

An additional issue in need of further
clarification is the treatment of Stability Bonds under national accounting
rules. In particular, the question of how the
national debt-to-GDP ratios would be affected by Stability Bonds under the
different guarantee structures needs to be explored. An important issue of
consideration will be the nature of any new issuing entity.

5.
Conclusions and way forward

The common issuance of Stability Bonds
by euro area Member States has significant potential benefits. These include the deepening of the internal market and rendering
capital markets more efficient, increasing the stability and shock resilience
of the financial sector and of government financing, raising the attractiveness
of euro area financial markets and the euro at global level, and reducing the
impact of excessive market pessimism on sovereign borrowing costs.

However, the introduction of Stability
Bonds is also associated with significant challenges. These must be convincingly addressed if the benefits are to be
fully realised and potential detrimental effects avoided. In particular, a
sufficiently robust framework for budgetary discipline and economic
competiveness at the national level and a more intrusive control of national
budgetary policies by the EU would be required, in particular for options with
joint and several guarantees to limit moral hazard among euro-area Member
States, underpin the credit quality of the Stability Bond and assure legal
certainty.

The many options for common issuance of Stability
Bonds can be categorised in three broad approaches.
These approaches imply the full substitution of Stability Bond issuance for
national issuance under a joint and several guarantees, a partial substitution
of Stability Bond issuance for national issuance under similar guarantees and a
partial substitution of Stability Bond issuance for national issuance under
several guarantees. These options present different trade-offs between the
expected benefits and pre-conditions to be met.

In particuar due to different degrees of
required changes to the EU Treaty (TFEU), the various options would require
different degrees of implementation time. The most
far-reaching Approach No 1 would seem to require the most far-reaching Treaty
changes and administrative preparations both because of the introduction of the
common bonds as such and the parallel strengthening of economic governance.
Approach No 2 would also require considerable lead-time. In contrast, Approach
No 3 would seem feasible without major Treaty changes and therefore less delay
in implementation.

The suggestions and findings in this
paper are still of exploratory nature and the list of issues to be considered
is not necessarily exhaustive. Furthermore, many of
the potential benefits and challenges are presented only in qualitative terms.
A detailed quantification of these various aspects would be intrinsically
difficult and/or will require more analysis and input from various sides. Also,
in many instances, the problems to be resolved or decisions to be taken are
identified but not resolved.

In order to advance on this issue, more
analytical work and consultation are indispensable.
Several of the key concepts, possible objectives and benefits, requirements and
implementation challenges merit a more detailed consideration and analysis. The
views of key stakeholders in this respect are essential. In particular, Member
States, financial market operators, financial market industry associations,
academics, within the EU and beyond, and the wider public should be adequately consulted.
The results of this consultation should be reflected in the further follow-up
of the potential launching of Stability Bonds.

Accordingly, the Commission has decided
to launch a broad consultation[29]
on this Green Paper, which will close on [8 January 2012][30]. The Commission will seek the views of all relevant stakeholders as
mentioned above and seek the advice of the other institutions. On the basis of
this feedback, the Commission will indicate its views on the appropriate way
forward by [mid February 2012].

Annex 1: Basic figures on government bond markets

Member State || General government debt || Central govern­ment debt || Govern­ment bond yields || CDS spreads || Credit rating

|| EUR billion, end 2010 || % of GDP, end 2010 || % of euro area, end 2010 || % of GDP, end 2010 || % p.a., 10 years, 8/11/2011 || Basis points p.a.; 5-year contracts, 8/11/2011 || Standard & Poor's, 8/11/2011

Belgium || 340.7 || 96.2 || 4.4 || 87.7 || 4.3 || 292.9 || AA+

Germany || 2061.8 || 83.2 || 26.4 || 53.2 || 1.8 || 89.3 || AAA

Estonia || 1.0 || 6.7 || 0.0 || 3.3 || n.a. || n.a. || AA-

Greece || 329.4 || 144.9 || 4.2 || 155.6 || 27.8 || n.a. || CC

Spain || 641.8 || 61 || 8.2 || 52.3 || 5.6 || 400.1 || AA-

France || 1591.2 || 82.3 || 20.3 || 67.8 || 3.1 || 183.8 || AAA

Ireland || 148.0 || 94.9 || 1.9 || 94.3 || 8.0 || 729.7 || BBB+

Italy || 1842.8 || 118.4 || 23.6 || 111.7 || 6.8 || 520.7 || A

Cyprus || 10.7 || 61.5 || 0.1 || 102.6 || 10.1 || n.a. || BBB-

Luxembourg || 7.7 || 19.1 || 0.1 || 17.4 || n.a. || n.a. || AAA

Malta || 4.3 || 69 || 0.1 || 68.9 || n.a. || n.a. || A

Netherlands || 369.9 || 62.9 || 4.7 || 57.3 || 2.2 || 99.6 || AAA

Austria || 205.6 || 71.8 || 2.6 || 66.2 || 3.0 || 159.9 || AAA

Portugal || 161.3 || 93.3 || 2.1 || 91.2 || 11.6 || 1050.9 || BBB-

Slovenia || 13.7 || 38.8 || 0.2 || 37.3 || 6.0 || 304.25 || AA-

Slovakia || 27.0 || 41 || 0.3 || 40.1 || 4.0 || 221.2 || A+

Finland || 87.0 || 48.3 || 1.1 || 43.9 || 2.3 || 60.63 || AAA

Euro area || 7822.4 || 85.4 || 100 || 71.6 || n.a. || n.a. || n.a.

p.i.: USA || 10258 || 94.4 || || || 2.08 || 47.5 || AA+

Source: Eurostat, IMF, S&P, Bloomberg

Annex 2: Concise
review of the literature on Stability Bonds

Academics, financial
analysts and policy-makers have published many papers on the idea of Eurobonds
(Stability Bonds). This annex summarises those contributions published so far,
by grouping them according to basic features of the proposals.

– Credit quality and guarantee structure:
Most of the authors emphasise the importance of the safe haven status that Eurobonds
should have and which would be reflected by the rating. The highest credit
quality would be secured mainly through guarantee structure and/or seniority
status. Two basic guarantee types to be embedded in Eurobonds emerge from the
literature: (i) joint and several (Jones, Delpla and von Weizsäcker,
Barclays Capital, Favero and Missale, J.P. Morgan) in which each country each
year guarantees the entire Eurobond issuance and (ii) pro-rata (Juncker and
Tremonti, De Grauwe and Moesen, BBVA) in which a country guarantees only a
fixed share of the issuance. Favero and Missale emphasise that a Eurobond
backed by joint and several guarantees could reduce exposure to crisis
transmission and contagion. On the other hand, authors supporting the pro-rata
guarantee argue that it reduces moral hazard. Capaldi combines a pro-rata
guarantee with credit enhancements (cash buffer, over-guarantee, capital, etc)
to ensure the highest credit rating. Delpla and Weizsäcker, Barclays Capital,
Dübel propose to ensure the credit quality of Eurobonds by making them superior
to national bonds, arguing that even in the extreme case of a sovereign default
the recovery value would be high enough to fully serve the senior bonds. Dübel
presents a slightly different approach of partial insurance of sovereign
(senior) bonds by the ESM.

– Moral hazard: Moral hazard due to weaker
incentives for fiscal discipline is the main argument used against Stability
Bonds and the most widely discussed issue in all the proposals (in particular
by Issing). Some authors propose limits on the volume of Eurobonds issued on
behalf of Member States, often following the debt ceiling of 60% as defined in
the SGP. Any additional borrowing needs should be financed by national bonds.
This idea is explored in the Blue bond concept by Delpla and von Weizsäcker,
which suggests a split of the issuance between Blue bonds, i.e. extremely
liquid and safe (guaranteed jointly and severally by participating countries)
bonds with senior status, and Red bonds - purely national with junior status.
The pricing of red bonds would create incentives for governments to keep the
budget under control. In a similar vein, Jones and Barclays Capital's propose
limits both on debt and on deficits that would allow for a gradual decline of
debt-to-GDP ratios. In addition to limiting the issuance of Eurobonds, Favero
and Missale propose to address moral hazard through a compensation scheme based
on the indexation of the interests paid by each Member State (as a function of
its credit risk premium or fiscal parameters). Boonstra, De Grauwe and Moesen,
BBVA and Natixis propose various types of a bonus/penalty system depending e.g.
on the capacity of different Member States to reduce their general government
deficit and debt.

– All authors agree that enhancement of fiscal discipline should be
the cornerstone of any Eurobond project, independent on the scope or guarantee
structure. Apart from the 'red'/national issuance, Favero and Missale suggest
restricting the participation to the Member States with the highest credit
rating or to issue only a short-maturity low-risk type of instrument such as
T-bills. Barclays, BBVA, Delpla and von Weizsäcker, Eijffinger, Becker and
Issing envisage establishing independent fiscal auditing bodies and special
euro-area bodies that would coordinate fiscal and economic policies. Under
Delpla's and Weizsäcker's sophisticated system, an independent stability
council would propose the annual allocation. This allocation would subsequently
be approved by the national parliaments of participating Member States, having
the ultimate budgetary authority required to issue the (Blue) Eurobond mutual
guarantees. Any country voting against the proposed allocation would thereby
decide to neither issue any (Blue) Eurobonds in the coming year nor guarantee
any Blue bonds of that particular vintage. Boonstra proposes that countries
that break the rules should immediately be severely punished, e.g. by losing
funds from the EU budget and losing political influence of the voting right in
the bodies of the ECB.

– Practical aspects of issuance: Most
authors propose establishing a joint debt agency that would coordinate the
issuance and manage the debt. In the Blue-Red bonds type of proposals the
issuance of the national part of the debt would remain with the national
treasuries.

– Scope of participating countries: Becker
enumerates options for the participation in the Eurobond. Those could be:
(i) common bonds issued by countries with the same rating; (ii) joint
bonds on an ad hoc basis similar to the joint bonds issued by some German
federal states; (iii) participation in a common government bond only when EMU
countries qualify through solid fiscal consolidation in boom times, or
(iv) Germany and France promoting one liquid short-term instrument or a
joint European market for treasury bills only.

Annex 3: Overview
of related existing instruments

1.         European
Union

The European Commission, on behalf of the
European Union, currently operates three programmes under which it may grant
loans by issuing debt instruments in the capital markets, usually on a
back-to-back basis. All facilities provide sovereign lending. The EU is
empowered by the Treaty on the Functioning of the EU to adopt borrowing and
guarantee programmes that mobilise the financial resources to fulfil its
mandate.

– Under the BoP programme the EU provides financial assistance
to non-euro area Member States that are seriously threatened with
balance-of-payments (BOP) difficulties (Art. 143 TFEU).

– Under the EFSM programme, the European Commission is
empowered to contract borrowings on behalf of the EU for the purpose of funding
loans made under the European Financial Stability Mechanism (Council Regulation
No 407/2010 of 11 May 2010). Since December 2010, support programmes for
Ireland and Portugal have been agreed on for EUR 22.5 billion and EUR 26
billion, respectively.

– The MFA programme is providing loans to countries outside the
European Union. Macro-Financial Assistance (MFA) is a policy-based financial
instrument of untied and undesignated balance-of-payments support to partner
third countries (Art. 212 and 213 TFEU). It takes the form of
medium/long-term loans or grants, or a combination of these, and complements
financing provided in the context of an International Monetary Fund's reform
programme[31].

Credit Rating

The EU’s AAA rating is a reflection of
several factors. Borrowings are direct and unconditional obligations of the EU
and guaranteed by all EU Member States. Budget resources are derived almost
entirely from revenue paid by Member States independently of national
parliaments including tariffs and duties on imports into the EU and levies on
each Member State’s VAT receipts and GNI. On this basis, bonds issued by the EU
are zero-risk weighted and can be used as collateral at the ECB.

For all borrowings, investors are ultimately
exposed to the credit risk of the EU, not to that of the beneficiaries of loans
funded. Should a beneficiary country default, the payment will be made from the
EU budget (EUR 127 billion in 2011). EU Member States are legally obliged by
the EU Treaty to provide funds to meet all EU’s obligations.

Key Features of EU issuance

The EU has so far issued benchmark-size bonds
under its Euro Medium Term Note programme (EMTN), which has been upsized to EUR
80 billion to take into account issuance under the EFSM. The resumption in
benchmark issuance started end of 2008, driven by the crisis.

With the activation of EFSM for Ireland and
Portugal, the EU has become a frequent benchmark issuer. The total borrowing
plan for the EFSM for 2011 amounts to about EUR 28 billion (EUR 13.9 billion
for Ireland, EUR 14.1 billion for Portugal; under BoP and MFA: about EUR 2
billion). Funding is exclusively denominated in euro.

As EU assistance is of a medium-term nature,
the maturity spectrum is normally 5 to 10 years, but can be expanded to a range
from 3 to 15 or occasionally 30 years.

“Back-to-back” on-lending ensures that the EU
budget does not assume any interest rate or foreign exchange risk.
Notwithstanding the back-to-back methodology, the debt service of the bond is
the obligation of the European Union which will ensure that all bond payments
are made in a timely manner.

As a frequent benchmark borrower, within the
above parameters the EU intends to build a liquid yield curve. The EU commits
lead managers to provide an active secondary market, quoting two-way prices at
all times and it monitors that such commitments are applied.

Determination of EU funding

EU loans are financed exclusively with funds
raised on the capital markets and not by the other Member States nor from the
budget.

The funds raised are in principle lent
back-to-back to the beneficiary country, i.e. with the same coupon, maturity
and amount. This back-to-back principle imposes constraints on EU issuance,
i.e. the characteristics of the issued financial instruments are defined by the
lending transaction, thus implying that it is not possible to fund a maturity
or amount different from the loan.

The Council Decision determines the overall
amount of the country programme, instalments and the maximum average maturity
of the loan package. Subsequently, the Commission and the beneficiary country
have to agree loan/funding parameters, instalments and tranches thereof. In
addition, all but the first instalment of the loan depend on compliance with
various policy conditions similar to those of IMF packages, which is another
factor influencing timing of funding. This implies that timing and maturities
of issuance are dependent on the related EU lending activity.

EFSM Process

(1)
A Member State which is threatened with a severe
economic or financial disturbance caused by exceptional occurrences beyond its
control may request support from the EU under the EFSM.

(2)
The Council of the EU decides by qualified
majority voting, based on a recommendation by the European Commission.

(3)
The Member State negotiates an economic adjustment
programme with the European Commission, in liaison with the IMF and the ECB.

(4)
The beneficiary Member State negotiates with the
European Commission the details of a Memorandum of Understanding (MoU) and a
loan agreement and decides on implementation.

(5)
Following signature of the MoU and Loan
Agreement, and a request for disbursements by the beneficiary Member State,
funds are raised in international capital markets and the first tranche is
released. Subsequent tranches of the loan are released, once the EU Council has
assessed the Member State's compliance with the programme conditionality.

2.         European
Financial Stability Facility (EFSF)

The European Financial Stability Facility
(EFSF 1.0) was created by the euro area Member States (EA MS) following the
decision taken on 9 May 2010 by the ECOFIN Council. The EFSF 1.0 was founded as
Luxembourg-registered company. The main purpose of the EFSF is to provide
financial assistance to euro area Member States. As part of an overall
assistance package of EUR 750 bn, the EFSF received guarantees by euro area
Member States totalling EUR 440 billion for on-lending to euro area MS in
financial difficulty, subject to conditionality in the context of an EU/IMF
economic adjustment programme.

Lending capacity

Under EFSF 1.0 the effective lending
capacity of the EFSF is limited to EUR 255 billion in order to preserve the AAA
rating of EFSF's bonds (see below).

Credit Rating

The EFSF 1.0 has been AAA rated by credit
rating agencies. However, under the initial agreement (EFSF 1.0), this has come
at the expense of a reduced lending capacity, as each EFSF loan has to be
covered by i) guarantees from AAA-rated sovereigns; ii) an amount of
cash equal to the relevant portion of the EFSF cash reserve; and iii) a loan-specific
cash buffer. The AAA rating is essentially based on the following four
elements:

(1)
Guarantee mechanism: The guarantee agreement between the euro area Member States requires them to issue an
irrevocable and unconditional guarantee for the scheduled payments of interest
and principal due on funding instruments issued by the EFSF. Furthermore, the
guarantee covers up to 120% of each euro area Member
State's share of any EFSF obligations (principal and
interest), which is however capped by the respective Guarantee Commitments as
stipulated in Annex 1 of the EFSF Framework Agreement. Any shortfall due
to this cap would be covered by the cash reserves and cash buffer.

(2)
Cash reserve:
Funds distributed to a borrower will be net of an up-front service fee, which
is calculated as 50 bps on the aggregated principal amount of each loan and the
net present value of the interest rate margin that would accrue on each loan at
the contractual rate until its scheduled maturity date.

(3)
Loan-specific cash buffer: Each time a loan is provided to a Member State, the EFSF has to
establish a loan-specific cash buffer, in a size so that each EFSF loan is
fully covered by AAA guarantees and an amount of cash equal to the relevant
portion of the EFSF cash reserve plus this respective loan- specific cash
buffer.

(4)
Potential additional support: Under the EFSF Framework Agreement, the size of the EFSF Programme
could be modified by unanimous approval by the guarantors. However, the
capacity of the EFSF cannot be increased indefinitely, as this may deteriorate
the credit position of the guaranteeing AAA-sovereigns. Should any of these
loose its AAA rating, the capacity of the EFSF would shrink by the guarantee
amount provided by that country.

Bonds issued by the EFSF are zero
risk-weighted and ECB repo-eligible. The credit rating of the EFSF could be
negatively affected by a potential deterioration in the creditworthiness of
euro area Member States,
especially the AAA-rated guarantors. As the EFSF is several guaranteed, a
single rating downgrade of a guaranteeing AAA-sovereign would downgrade the AAA
rating of the EFSF, if no further credit enhancements are put in place.

Conditionality

Any financial assistance by the EFSF linked to the existence of an
economic adjustment programme including strict policy conditionality as set out
in a Memorandum of Understanding (MoU). The Commission negotiates with the beneficiary
country the MoU in liaison with the ECB and IMF.

Decision making

The decisions to grant funds under the EFSF
are taken unanimously.

3.         European
Financial Stability Facility (EFSF 2.0)

The EFSF Framework Agreement has been
modified in order to have the full lending capacity of EUR 440 billion
available.

Lending capacity

Under EFSF 2.0 the
effective lending capacity of the EFSF is limited to EUR 440 billion in order
to preserve the AAA rating of EFSF's bonds (see below).

Credit Rating

The EFSF 2.0 has received a AAA rating by
credit rating agencies. To increase the effective EFSF lending capacity to a
maximum of EUR 440 billion, a revision of the EFSF Framework Agreement has been
made with a view to having an increase in the guarantees from AAA-rated
sovereigns to EUR 440 bn. Essentially, then, the AAA rating is based on one
element only, the guarantee mechanism.

That guarantee agreement between the EA
Member States requires them to issue an irrevocable and unconditional guarantee
for the scheduled payments of interest and principal due on funding instruments
issued by the EFSF. Furthermore, the guarantee covers up to 165% of each euro area
Member State's share of any EFSF obligations (principal and interest), which is
however capped by the respective Guarantee Commitments as stipulated in Annex 1
of the EFSF Framework Agreement. Bonds issued by the EFSF are zero
risk-weighted and ECB repo-eligible.

The credit rating of the EFSF could be
negatively affected by a potential deterioration in the creditworthiness of any
euro area Member State, especially of any AAA-rated guarantor. As the EFSF is
several guaranteed, a single rating downgrade of a guaranteeing AAA-sovereign
would downgrade the AAA rating of the EFSF, if no further credit enhancements
are put in place.

Conditionality

Any financial assistance by the EFSF is
linked to strict policy conditionality as set out in a Memorandum of
Understanding (MoU). The Commission negotiates with the beneficiary country the
MoU in liaison with the ECB and IMF. Beyond loans within a macroeconomic
adjustment programme, the EFSF can also grant credit lines, carry out
operations on the primary and secondary bond markets and grant loans outside of
programmes for recapitalising financial institutions.

Decision making

The decisions to grant
funds under the EFSF are taken unanimously.

4.         European
Stability Mechanism (ESM)

On 24-25 March 2011, EU Heads of States and
Governments endorsed the creation of the ESM as a permanent crisis mechanism to
safeguard the euro and financial stability in Europe. The ESM will be world
largest international financial institution, with an EUR 700 billion capital,
of which EUR 80 billion will be paid in. The entry into force of the ESM was
initially planned for July 2013, but is expected to be advanced to mid 2012.

5.         German
Länder joint bonds

A special segment of the German Länder
(states) bond market is the so called Jumbos. These are bonds issued by a group
of German states. Up to now, 38 Jumbos have been issued by syndicates of five
to seven states, with the exception of the particularly large Jumbo of 1997
which was shared by ten states. So far, all Jumbos have been arranged as
straight bonds and the average issue size is slightly higher than EUR 1
billion, more than seven times the size of an average Land issue. Participants
of the Jumbo programme are mostly states which are either small by size or
population. Jumbos are more liquid than typical Länder bonds, saving the state
treasurers part of the liquidity risk premium compared to a rather small
single-issuer bond. From the investors' point of view, a Jumbo constitutes a
structured bond composed of separate claims against the participating states
according to their share in the joint issue. Thus, the states are severally but
not jointly liable for the issue.

Bond characteristics

– Issuance frequency: usually 2-3 issues per year

– Maturities: 5-10 years

– Size: EUR 1-1.5bn

– One state coordinates the issue and acts as a paying agent.

Credit Rating

The issues are rated AAA by Fitch. Background
is that Fitch until recently assigned AAA ratings to all German states because
of the Länderfinanzausgleich (this is an equalisation process which is a solidarity
and implicit guarantee mechanism between the Länder and ultimately the federal
state). This also explains the often split ratings between Fitch and the other
agencies. Note that not all German Länder are rated by Fitch any more.

According to Fitch, the AAA rating reflects
the individual creditworthiness of all seven German federated states involved
in the joint issuance. It is based on the strong support mechanisms that apply
to all members of the German Federation and the extensive liquidity facilities
they benefit from, which ensure timely payment and equate the creditworthiness
of the states to that of the Federal Republic of Germany. Fitch notes that the
support mechanisms apply uniformly to all members of the German Federation: the
federal government (Bund) and the 16 federated states. The differences in the
federated states' economic and financial performances are irrelevant, as all
Länder are equally entitled to financial support from the federal government in
the event of financial distress. German Länder joint bonds are zero-risk-weighted
and ECB repo-eligible.

Annex 4:
Documentation and market conventions

As mentioned in Section 4, the
introduction of a Stability Bond would require determining various
security characteristics and market conventions would need to be determined.
These would possibly include:

– Jurisdiction of Stability Bond issuance:
EFSF and EU/EFSM bonds are issued under English law, but this may be meet
political resistance in this case.

– Maturity structure of securities: The funding
strategy of the Stability Bond should be determined with a view to i) develop a
benchmark issues and a yield curve, and ii) to optimise funding costs, as
issuing in some segments of the yield curve is more costly than for others. The
issuance of short-term paper (t-bills) in addition to longer maturities would
improve the flexibility of the treasury and would improve access to funding
significantly.

– Coupon types (fixed, variable, zero, inflation-linked): For a start and to
facilitate the development of benchmark status, it may be preferable to
concentrate on plain vanilla security structures. This would also facilitate
the development of related derivative instruments, in particular options and
futures.

– Stock exchange on which securities would be listed: EFSF and EU/EFSM bonds are currently listed on the Luxembourg
exchange. For the Stability Bond this may prove to be too limited although
listing on several exchanges would involve additional costs.

– Settlement conventions: These
conventions should be set with a view to support the attractiveness of the
instruments, i.e. for short-term paper with t+1 (to facility short-term
treasury objectives) and for longer-term securities with t+3 (to minimize the
risk of settlement failures).

– Strategy to create and maintain an investor basis: Relationships with potential investors would need to be
established and could require decisions on whether a group of primary dealers
will need to be established, how the retail sector will be integrated, etc.

– Introduction of Collective Action Clauses, to allow for an
organised procedure to resolve any future solvency issues.

References

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[1]                      The public discussion and literature normally uses the term
"Eurobonds". The Commission considers that the main feature of such
an instrument would be enhanced financial stability in the euro area.
Therefore, in line with President Barroso's State of the Union address on 28
September 2011, this Green Paper refers to "Stability Bonds".

[2]                      In
principle, common issuance could also extend to non-euro area Member States but
would imply exchange rate risk. Several non-euro area Member States have
already a large part of their obligations denominated in euro, so this should
not represent a significant obstacle. All EU Member States might have an
interest in joining the Stability Bond, especially if that would help reducing
and securing their funding costs and generates positive effects on the economy
through the internal market. From the point of view of the Stability Bond, the
higher the number of Member States participates, the bigger are likely to be
the positive effects, notably stemming from larger liquidity.

[3]               Giovannini Group: Report on co-ordinated issuance of
public debt in the euro area (11/2000). http://ec.europa.eu/economy_finance/publications/giovannini/giovannini081100en.pdf.

[4]               See A European Primary Dealers Association Report
Points to the Viability of a Common European Government Bond, http://www.sifma.org/news/news.aspx?id=7436.

[5]               See Annex 2 for an overview of analytical contributions
to the Stability Bonds debate.

[6]               European Parliament Resolution of 6 July 2011 on the
financial, economic and social crisis: recommendations concerning the measures
and initiatives to be taken (2010/2242(INI)) states:
" ...13. Calls on the Commission to carry out an investigation into a
future system of Eurobonds, with a view to determining the conditions under
which such a system would be beneficial to all participating Member States and
to the euro area as a whole; points out that Eurobonds would offer a viable
alternative to the US dollar bond market, and that they could foster
integration of the European sovereign debt market, lower borrowing costs,
increase liquidity, budgetary discipline and compliance with the Stability and
Growth Pact (SGP), promote coordinated structural reforms, and make capital
markets more stable, which will foster the idea of the euro as a global ‘safe
haven’; recalls that the common issuance of Eurobonds requires a further move
towards a common economic and fiscal policy;
14. Stresses, therefore, that when Eurobonds are to be issued, their issuance
should be limited to a debt ratio of 60% of GDP under joint and several
liability as senior sovereign debt, and should be linked to incentives to
reduce sovereign debt to that level; suggests that the overarching aim of
Eurobonds should be to reduce sovereign debt and to avoid moral hazard and
prevent speculation against the euro; notes that access to such Eurobonds would
require agreement on, and implementation of, measurable programmes of debt
reduction;".

[7]               E.g. bonds issued by the Commission under the Balance
of Payments Facility/EFSM and bonds issued by the EFSF or issuance to finance
large-scale infrastructure projects with a cross-country dimension
(e.g. project bonds to be possibly issued by the Commission). The various
types of joint issuance and other instruments similar to Stability Bonds are
discussed in Annex 3.

[8]               The issuance sizes as recorded in Dealogic have been
adjusted to incorporate the size of adjacent issuances with similar maturity
and settlement date. To adjust for differences in time-dependent market
conditions, control variables are introduced for the impact of the level of the
interest rate (the 2-year swap rate) and of the term structure (the difference
between the 10-year and the 2-year swap rates) prevailing at the time of each
issuance.

[9]               Proposal for a Regulation of the European Parliament
and of the Council on common provisions for monitoring and assessing draft
budgetary plans and ensuring the correction of excessive deficit of the Member
States in the euro area; Proposal for a Regulation of the European Parliament
and of the Council on common provisions for monitoring and assessing draft
budgetary plans and ensuring the correction of excessive deficit of the Member
States in the euro area.

[10]                    The
experience of rating the EFSF bonds has showed that a rating of the bond
superior to the average guarantees made by participating Member States was
accomplished by different tools such as holding cash buffers, loss-absorbing
capital and over-guaranteeing the issuance size. While these elements have been
complex to manage in the case of the EFSF, they may prove useful in reinforcing
the credit rating of the Stability Bond.

[11]             In this section, the terms several
guarantee and joint and several guarantee are used in an economic
sense that may not be identical to their legal definitions.

[12]             Such as an EU budget or ECB capital key.

[13]             However, in such circumstances, participating Member
States would have a claim on the defaulting Member State.

[14]             For example, the German Constitutional Court ruling of
7 September 2011 prohibits the German legislative body to establish a permanent
mechanism, "which would result in an assumption of liability for other
Member States' voluntary decisions, especially if they have consequences whose
impact is difficult to calculate." It also requires that also in a
system of intergovernmental governance, the Parliament must remain in control
of fundamental budget policy decisions.

[15]             A fourth approach involving full substitution of Stability
Bonds and several but not joint guarantees would also be possible but is not
considered, as it would not be materially different from the existing issuance
arrangements. In addition, hybrid cases could be conceived, for example several
guarantees on debt obligations coupled with a limited joint guarantee to cover
short-term liquidity gaps.

[16]             See section 4 for a review of the advantages and
disadvantages of centralised and decentralised issuance.

[17]             This is the case in particular for Germany and to a
lesser extent for Spain and France.

[18]             This narrow coverage of Stability Bonds would imply
that Member States would have to commit not to issue own national, or other
sovereign, bonds, including their sub-federal entities if these are included in
the system of joint issuance.

[19]             See Delpla, J. and von Weizsäcker, J. (2010). They proposed a debt ceiling of 60% of GDP, motivated by the
Maastricht criteria.

[20]             As in Approach No. 1, Stability Bond issuance could be
conducted on a decentralised basis, but would probably be more efficiently
managed by a central debt management agency.

[21]             Such a subordinate status of national bonds could only
apply to newly issued national bonds, i.e. national bonds issued after the
introduction of Stability Bonds. Conversely, outstanding "old" or
"legacy" national bonds would have to enjoy the same status as
Stability Bonds, because a change of their status would, technically, amount to
a default.

[22]             Delpla and von Weizsäcker argue that, due to the high
default risk, red debt should largely be kept out of the banking system, by
becoming no longer eligible for ECB refinancing operations and subject to
painful capital requirements in the banking system.

[23]             The proposal by Bruegel sets the ceiling at 60% of GDP,
using the Maastricht criterion as reference but other proposals with even lower
ceilings have been made. Indeed, it has been argued that a sufficiently low
ceiling virtually guarantees zero default risk on Eurobonds. A standard
assumption in the pricing of default risks is that in the case of default 40%
of the debt can be recovered. Applying this consideration to sovereign debt, a
ceiling below the recovery value would imply that the debt issued under the
common scheme will be served under any condition.

[24]             Published on 9 Nov. 2011, http://www.sachverstaendigenrat-wirtschaft.de/aktuellesjahrsgutachten.html,
paragraphs 9-13 and 184-197.

[25]             Such an approach was considered in the Giovannini Group
report (2000) – though through decentralised issuance and was more recently
proposed by De Grauwe and Moesen (2009), Monti (2010) and Juncker and
Tremonti (2010).

[26]             Similarly, but presumably needing a Treaty change,
Bini-Smaghi proposed a Eurobond with pro-rate guarantees but with the right to
issue debt transferred from Member States to a supra-national agency. The debt
could be issued up to levels agreed by the Council in the context of the yearly
approval of the stability programmes, which would made impossible issuing debt
to cover expenditure over the debt limit set every year. This way a "debt
brake" would be created, which would force a country to make an early
decision when its public debt gets too close to the agreed limit.

[27]             Even if in particular under approach no. 3
participation by Member States outside the euro area seems conceivable.

[28]             In transition there could be a COM agency with COM
staff and temporary national DMO staff that could be later transformed in a DMO
if necessary.

[29]             Feedback can be provided via all normal means,
including to a dedicated mailbox:
ECFIN-Green-Paper-Stability-Bonds@ec.europa.eu;
(webpage: http://ec.europa.eu/economy_finance/consultation/index_en.htm).

[30]             For the sake of a timely follow up, the deviation from
the normal consultation period of eight weeks seems justified by the fact that
the concept of Stability Bonds/Eurobonds has already been widely discussed for
a considerable amount of time.

[31]             For further information, see               
http://ec.europa.eu/economy_finance/eu_borrower/macro-financial_assistance/index_en.htm