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COVID-19 – EU bonds: Has the EU had its Hamilton moment?

AUTHORs: Richard Kelly Services: Finance and Capital Markets DATE: 23/07/2020

In the hit musical “Hamilton”, there is a song called Cabinet Battle #1.  In this song the first Secretary of State (and future President) of the US, Thomas Jefferson, and its first Treasury Secretary, Alexander Hamilton, (rap) battle about Hamilton’s 1790 plan for the newly formed United States of America to assume State debts.

Jefferson opposes the plan, rapping “If New York’s in debt why should Virginia bear it...  You just want to move our money around.”  Hamilton retorts “If we assume the debts the Union gets a new line of credit… If we’re aggressive and competitive the Union gets a boost; you’d rather give it a sedative?”

We previously discussed initial proposals for the EU to issue “Corona Bonds” as a way to address the financial challenges presented by the COVID-19 crisis.  The current debate bears striking similarity to that argument between Jefferson and Hamilton 230 years ago; perceived fiscally “prudent” EU Member States worry that any discussion of mutual bonds will simply amount to a cash transfer to perceived less prudent Member States (“You just want to move our money around”).

Nevertheless, after a marathon European Council meeting running from 17 – 21 July, the EU has agreed on a plan to drastically increase its capital markets bond issuance programmes, prompting comparisons to Hamilton’s plan and suggestions in the press that the EU has had its “Hamilton moment”.

What has been agreed?
In the final conclusions from the meeting the European Council agreed that as part of a recovery plan, known as “Next Generation EU” (NGEU), an “Own Resources Decision” is to be adopted which allows the EU to borrow funds on the capital markets up to an amount of EUR 750 billion.  The borrowing must be completed by 2026.

It is expected that bonds with multiple different maturity dates will be issued, as the European Council agreed that “[t]he repayment shall be scheduled in accordance with the principle of sound financial management, so as to ensure the steady and predictable reduction in liabilities until 31 December 2058.”  Having a number of issuances with different maturities (eg, 3 year, 5 year, 10 year etc) is seen as a pre-requisite for having a liquid market that is attractive to investors.

Is this completely new for the EU?
No.  The EU has issued bonds on the capital markets before, but on a much smaller scale.  The EU currently has about EUR 52 billion in outstanding bonds but these bonds were always issued for the purpose of funding a particular pre-defined project or programme.

What will the EU do with the money?
The EU must use the money raised solely to address the economic consequences of the COVID-19 crisis.  The funds will be disbursed to Member States as grants and loans via the EU’s existing instruments and programmes.  EUR 390 billion of the funds will be disbursed as grants (down from the EUR 500 billion initially proposed by the European Commission), with the remaining EUR 360 billion disbursed as loans.

How will the EU repay the bonds?
As noted above the bonds must be repaid in full by 31 December 2058.  It is proposed that the EU will, over the coming years, work to reform its “own resources” system as well as introducing new own resources to repay the bonds.

 As an initial step, from 1 January 2021 a new own resource will be introduced whereby the EU will receive revenue from a national contribution calculated on the weight of non-recycled plastic packaging waste in each Member State.  The European Commission will propose a carbon border adjustment mechanism and a digital levy, with a view to their introduction at the latest by 1 January 2023.  The European Commission will also propose a revised Emission Trading Scheme, possibly extending it to aviation and maritime.  Finally, in the course of its next budget (which will run from 2028) the EU will work towards the introduction of other own resources, which may include a Financial Transaction Tax.

What do the markets think?
Market players have reacted positively to the news.  In a global context US Treasury bonds are often seen as a safe haven for people wanting to invest US dollars.  However, there has been no similar safe haven for Euro investors.  For many years German bunds (German Government bonds) have acted as a proxy for a European equivalent of US Treasuries, but a shortage of German bunds has led to German bund yields being in heavily negative territory (the yield on 10 year German bunds is currently around -0.5%).

The new EU bonds will add another option for investors looking to invest in Euro assets.  It is expected that, as with existing EU bonds, the new bonds’ yields will not be as low as those on German bunds, and may even be in positive territory.  The fact that EUR 750 billion will be issued with different maturities over the next six years should mean there is sufficient investor appetite to maintain crucial liquidity.  Moreover, the EU is rated AAA/Aaa (the top investment grade) by Fitch Ratings and Moody’s Investors Service respectively, while S&P Global Ratings rates the EU AA (two steps below S&P’s highest investment grade), making it a highly attractive issuer.

What are the next steps?
The agreement reached by the European Council needs to be approved by the European Parliament and individual Member States (which may require the approval of some national parliaments).  Nonetheless there is general optimism that the package will be approved later this year.

Is this truly a “Hamilton moment” for the EU?
While some interesting parallels can be drawn, the EU’s proposal is nowhere near as ambitious as Hamilton’s plan.  The proposal does not call for existing Member State debt obligations to be assumed by the EU; rather it calls for a temporary mutualisation of some future debt obligations solely to meet the extraordinary circumstances created by the COVID-19 crisis.

That said, the idea that the EU can borrow extensively on the capital markets and, importantly, raise its own taxes to pay for such borrowings is a significant step in the development of the bloc, and is seen by some as the first step in the greater financial integration of the Member States.  For example S&P has said that the deal should improve the creditworthiness of individual Member States and moves to EU close to becoming a “fully fledged fiscal union”.

Ultimately it is too early to tell whether these proposals will be as significant as some imagine, or whether the politics behind the EU’s new bonds could someday inspire a hit show.