The European Union (EU) is discussing plans to issue pan-European sovereign debt to centralise the work being done by respective EU members’ central banks. The EU Recovery Fund (the Fund) will effectively monetise EU governments’ borrowings used to fund fiscal spending to combat the COVID-19 pandemic.
The plan is for the Fund to be of a sufficient magnitude so it can support the most affected EU sectors and geographical parts and avoid a prolonged 1930s style depression. The proposal is to gear up the Fund to create a borrowing programme of at least EUR1 trillion.
As with any decision by the EU, there is considerable debate over how the fund should operate, in particular whether it should provide loans or grants. The hardest hit countries such as Italy and Spain would like to receive the assistance as grants, or direct money transfers, but the more fiscally disciplined members such as the Netherlands, Austria and Germany seemingly prefer loans, albeit it at low interest rates. Either way, the Fund will borrow from financial markets for its assistance to member nations.
Almost all media reporting and comment has been on political debate within the EU, and on the form and amount of assistance to troubled EU members. I have not seen any comment on the Fund’s borrowing programme despite its immense implications for financial markets. It seems logical that the Fund will offer debt that is guaranteed joint and severally by all EU members. That would put the Fund’s debt on par with US Government debt, as a risk free sovereign guaranteed investment.
The key attraction of US Government debt has been as a risk free investment in the world’s reserve and trade currency. Investors, especially sovereign nations through their central bank or wealth funds wanting to diversify away from US Government debt, lack an alternative liquid, plentiful prime risk-free investment.
The gap between the yield on 10 year US Treasuries and German bunds is more than 100 basis points (1.00%), which is at odds with US Treasuries’ status as the world’s prime risk free investment because investors are demanding a 1.00% higher return from US Government bonds compared to German Government bonds over the next 10 years.
The Fund could provide a powerful alternative, especially if the world decides that the yields offered by US Government debt no longer compensates for the US’ risk.
Given the current strained relationship between China and the US, notably on matters of trade and coronavirus, the US should be worried that one of the largest holders of US Government debt could be tempted to put a chunk of its money somewhere else. Especially if that somewhere else is of equal risk and geopolitical importance. Where China’s money goes, others will follow.