Auf Wiedersehen, Mrs Merkel?Posted on: 06 June 2012 by Andrew Stallard
Will Eurobonds be the solution to the Eurocrisis?
The debate about whether Greece will remain in the Euro zone continues. Eurobonds are again being hailed as the solution to the Greek hokey-cokey dilemma (1). But what are Eurobonds? Do they possess any magical Euro-crisis solving properties? And how do they differ from one of our favourite financial planning emergency cash reserve recommendations, the humble Premium Bond (2)?
First a quick brush-up on history and economics: governments issue bonds to raise money and they can be regarded as a form of mortgage, there isn't much magical about them, sadly, but they are generally pretty reliable. UK government bonds are called gilts as the debt originally issued by the Bank of England was printed on gilt (or gilded) edged paper. UK government debt is regarded as a very low risk investment as the British Government has never reneged on its obligations.
Because of that, a gilt edged investment has come to mean a low-risk one and usually a low return, too. If you're an investor with a preference for lower-risk investments, however, gilts may well form a substantial part of your portfolio.
We always advise clients to hold an amount of 'emergency' money in a no risk investment and Premium Bonds issued by the Treasury can fulfil this requirement. Buy £1,000 of Premium Bonds and it will, you can be fairly sure, remain £1,000 of premium bonds. Inflation will eat into its value of course, but that is another article. Instead of paying interest monthly, Premium Bond prize draws are held with a £1 million jackpot and a million other prizes. You have immediate penalty-free access to your money and with average luck, returns should be 1.5%.
German government bonds are known as bunds and are issued in the same way as gilts are to finance government spending. As with the UK, their debt is regarded as very low risk. In the case of countries such as Italy, Spain and of course Greece, this is not the case.
Because of this greater risk of the government defaulting, these countries have to offer investors a vastly higher level of return on their Government debt. The German and UK Government can borrow money cheaply, while Italy, Spain and Portugal have to pay much higher rates and in the case of Greece, eye wateringly high rates.
On the flip side, German borrowing costs hit zero recently as investors sought to shelter their money before the Greek elections (3). The Eurobond idea would allow the weaker countries in the Eurozone to issue debt with the repayment being guaranteed by the German government and all the other stronger economies in the Eurozone.
And this is where the Eurobond comes in, to balance up some of the costs, good news for the 'Club Med' countries, but not such good news for the German tax payer, who would be directly underwriting the debt. The acceptance of the Eurobond would mean sharply higher borrowing costs in Germany and probably the end of Mrs Merkel’s political career as she has so far struggled to get even the much more limited support for Greece through the German parliament.
The Greek economy is small and it is perhaps surprising that the prospect of a Greek exit from the Euro has caused chaos on World stock markets. Markets hate uncertainty though, and the prospect of a disorderly Greek exit from the Euro, coupled with banks failing all over Europe, could tip the world into a much deeper recession.
Whether the Eurobond will save the Euro and keep Greece in the Euro is unclear but decisive action is needed soon to either retain Greece in the Euro or allow it to leave in a controlled fashion. Unless this is done there is little prospect of growth throughout the Eurozone and the risk of a decade of stagnation. For Germany, it's a stark choice: Mrs Merkel and the German tax payer either have to guarantee Greece's debt and stabilise financial markets, or point Greece to the sign marked 'Exit'.
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