Can stability bonds save the eurozone?

A majority of investors believe “stability bonds” could provide a partial solution to the euro zone sovereign debt crisis, but are concerned that these bonds carry a high moral-hazard risk, a CFA institute poll reveals.

The poll found 55 per cent of European investment professionals believe that the common issuance of stability bonds can help alleviate the debt crisis, but only as part of a package of structural reforms, fiscal integration, and a strong common governance framework.

The risk of moral hazard, where some member states may follow poor budgetary discipline with limited implications for their financing costs, is a key concern of CFA Institute members.

More than half of investors also believe the bonds will reinforce financial stability in the euro area and 56 per cent agree that it will facilitate the transmission of euro-area monetary policy.

“Stability bonds” are seen as an instrument to address liquidity constraints and ultimately reinforce financial stability in the euro area.

The poll of 798 investment professionals comes in the context of the European Commission’s consultation on the issuance of “stability bonds”.

The bonds are seen as creating a new way for governments to finance their debt, the European Commission says.

In a Green Paper outlining various potential models for a stability bond, the Commission says that the bonds will potentially offer a “safe and liquid” investment opportunity for savers and financial institutions.

The Commission claims that such a stability bond would be the catalyst for a euro-area-wide integrated bond market to rival the liquidity and size of its $US counterpart.

While a majority of respondents agree that resolution of the euro-area sovereign debt crisis should require common issuance of sovereign bonds, 40 per cent disagree with this strategy.

A common view from respondents is that the stability bonds could bring temporary relief in the short run, but will only postpone the problem and be detrimental in the long term, possibly fuelling the next crisis.

Some respondents believe the long-term negatives would outweigh the short-term benefits, as stability bonds would create further systemic risk, resulting in national sovereign debt crises being replaced with a Europe-wide debt crisis.

There is also a clear consensus among investors, however, on how the bonds should be issued.

Joint and several guarantees would be the most effective approach for the common issuance of stability bonds among member states of the euro area, according to 64 per cent of CFA members polled.

A partial substitution of stability bond issuance for national issuance – in which a portion of government financing needs would be covered by stability bonds, with the rest covered by national sovereign bonds – is supported by 64 per cent of CFA members.

Investors strongly advocate three key preconditions that countries wanting to access stability bonds would have to agree to. These are:

• Significant enhancement of economic, financial, and political integration (supported by 86 per cent).
• Increased surveillance and intrusiveness in the design and implementation of national fiscal policies (supported by 88 per cent).
• Limited access to the Stability Bonds in cases of non-compliance with a euro-area governance framework (supported by 90 per cent).

Agnès Le Thiec, CFA Institute’s capital markets policy director, says the new financial instruments, while helping to solve the euro zone debt crisis, cannot cure structural problems of imbalances in trade and competitiveness, or public debt, in many member states.

“Stability bonds also carry a high risk of moral hazard, and would therefore have to be associated with much more extensive structural reforms, fiscal integration and a strong common governance network,” Le Thiec says.