The ties that bond

I recently mentioned my disappointment that European leaders couldn’t seem to coordinate their positions on the financial crisis, as evidenced by agenda debates between the Italian G8 presidency and the British G20 presidency. But the past few days have renewed hope that maybe, just maybe, Europe can act together on important issues. As the Financial Times noted in a particularly caustic editorial: “Finally, European Union leaders have sent a signal that they can display leadership. At their weekend Berlin summit they made a genuine effort to forge a common policy in advance of the Group of 20 meeting in London in April. That offered a reassuring contrast to earlier episodes of national egotism.”

The FT’s change of heart about European capacity to coordinate was precipitated by Angela Merkel, who explored the idea of joint sovereign bonds, and the EU Monetary Affairs Commissioner suggested yesterday that members facing financial crises would be able to turn to Europe before turning to the IMF (a statement made with Ireland in mind). The first idea in particular interests me, given my ongoing research on sovereign bonds and political risk. While Venezuela and Argentina have considered issuing joint sovereign bonds, the idea hasn’t been actively explored by European policy makers, and the political risks of issuing such bonds has not been sufficiently explored. But I have written a chapter in a book called The Geo Politics of the City on the potential impact of politics on such bonds, I thought it might be worth sharing.  And at the risk of boring some of my readers senseless, I have copied out an excerpt to give a sense of what my research suggests…

“While the transactional benefits of integrated European bond markets have been well explored, there has been less attention paid to how such bonds would be received by the financial markets and in particular their likely impact on two inter-related variables: perceived creditworthiness and the perception of political risk.

It is unclear whether such joint bonds would be seen as exceptionally credible – a risk shared jointly amongst several of the world’s largest and most creditworthy economies – and thereby enjoy the highest possible rating, such as the bonds issued by the World Bank which are guaranteed by all of its members,or whether the bonds would be lacking in credibility due to uncertainty about the ongoing and multi-track European “project” and the credibility of smaller / more indebted countries.

A related concern is how the market would price political risk in such bonds. Political risk could either be evaluated exclusively at the supra-national level – essentially a judgement about the European “project” – or it could be the aggregation of all underlying political risks across member states. For example, riots in Budapest could conceivably be reflected as a risk premium or volatility in such a bond if Hungary helped to guarantee it or benefited from the bonds proceeds.

The findings… confirm that European bond yields are partially explained by reference to their underlying political characteristics, and in particular, the dispersion of power and authority within each polity. The results – that increases in checks and balances are positive for credibility whereas increase in government and legislative fractionalisation negatively impact credibility – provides some scope for analysing the competing hypothesis presented above.

If European supra-national bonds were to be issued, there would likely be little political premium applied on the basis of an increasing number of veto players. Layered institutions – where veto players are present at various levels of the policy cycle – appear to have a positive rather than negative impact on European credibility. This is potentially because of insulation from the impact of any particular veto player. However, the fact that government and legislative fractionalisation has a negative impact on credibility suggests that there is a significant risk that as European governance fractionalises to accommodate a variety of national and international parties, there would be credibility losses.

This would probably be the case in particular if the European Parliament had a strong role in allocation of expenditure from bond proceeds, as there fractionalisation is high. If in contrast issuance and allocation of proceeds was completed centrally – by the European Central Bank or by the President or Commission – the risk premium paid on such bonds would likely be lower. A pan European bond would not necessarily be penalised for multi-level governance, and strong buy in and leadership from European institutions could minimise the impact of fractionalised government on the price of European bonds.”