‘Big leap forward’ needed to propel EU to safe asset status

When Jean-Claude Juncker, then-president-elect of the European Commission, brought forward the idea of a Capital Markets Union (CMU) for the EU in July 2014, there was widespread excitement at the prospect of a single market for capital for the bloc within five years.

Developing a European capital market was not a new concept. It had existed for nearly half a century, if not longer. Still, Juncker – and the Commission officially in 2015 – painted an attractive picture of lowering both the costs of capital raising and Europe’s dependence on bank funding by making it a more attractive place to invest.

A decade on — and five years past the Commission’s initial target of putting in place a “well-functioning and integrated” Union — CMU remains a concept.

“Despite a number of valuable endeavours promoted by the European Commission over the past decade, the CMU initiative has been less than a game changer so far,” says Nicolas Véron, the French economist and founder of Brussels think tank, Bruegel.

Some believe that the lack of a common safe asset was one of the key hurdles to speeding up the development of the CMU.

Among the big hindrances to achieving CMU, Fabio Panetta, former member of the European Central Bank’s executive board and now Bank of Italy governor, has highlighted “two critical blind spots” of which the most important was the lack of an EU safe asset.

“Establishing such a permanent European safe asset would be a game changer, but it hinges on Europe having a standing fiscal capacity with a borrowing function,” he said in an ECB blog post published in August last year — nearly three years after the Commission adopted a new CMU action plan in September 2020. “Without that, building a deep and competitive CMU will prove much more difficult.”

The EU has contenders to be a safe asset — German Bunds, or the bonds of its supranational institutions such as the European Investment Bank, European Financial Stability Facility, or the European Stability Mechanism.

Bonds from these issuers carry top credit ratings and are liquid, fitting into the commonly recognised characteristics of creditworthiness, robustness and liquidity for safe assets.

More recently, the EU itself has begun to issue roughly €150bn a year as it raises money to help member states recover from the pandemic. Given the borrower’s intent to be seen as a sovereign issuer, this also puts it into consideration to be the bloc’s safe asset.

Outstanding bonds from the four EU-wide issuers hit €1tr earlier this year.

The significance of a European safe asset would be in helping the continent achieve a securities market akin to one with the frictionless uniformity of the US.

A standardised, common safe asset is one of the most important elements in effectively creating a common market for debt securities in Europe. It would reduce fragmentation while giving the market an instrument by which to price risk via a straightforward benchmark and hedging instrument, argues Bryan Pascoe, chief executive of the International Capital Markets Association.

However, the reality is that the EU would need to get the agreement of 27 member states, with their history of centuries of diverse national traditions and laws that have been developed to serve particular purposes. The structural, legal and political complexity of creating a simple, consistent market makes achieving it a distant prospect.

Previous ideas around creating a safe asset have involved complicated processes of tranching and pooling liabilities, in some cases creating securitised assets, such as sovereign bond-backed securities. That has created a political debate over such debt mutualisation

But the EU’s rise as a jumbo issuer may offer a more straightforward solution. It was a small issuer with just €50bn of issuance under its belt in 2019 but by the end of this year, outstanding EU bonds will hit €500bn, and €1tr by 2026.

Defining the EU as an issuer had never been a problem before its debt load ballooned. While the bloc has a degree of sovereignty, it is not a sovereign in and of itself. But considering it a supranational issuer throws up other problems in the context of the bond market in that it has now outgrown all of its supranational peers.

That has led some market participants to resort to the word ‘hybrid’ when trying to classify the EU, while the issuer itself is lobbying hard to be considered a sovereign borrower, which extends to being included in government bond indices.

“The EU is pushing for it like you wouldn’t believe,” said a senior public sector bond originator. “To me, they are not a sovereign. But they will get that status anyway.”

The EU says its institutional structure is not like that of a typical supranational, and the EU bond market has some of the characteristics of a large, liquid European government bond market.

“It makes sense from a market perspective,” says a Commission official. “In terms of its legal nature, the EU is not a sovereign and has no ambition to become one. But that doesn’t necessarily mean it is an issuer that belongs to the [supranational and agency] market.”

The volume of outstanding bonds “just don’t fit in the SSA market anymore”, the official adds. The European Commission calculates that the EU’s weight in SSA indices will reach 60%-70% by 2026, therefore creating concentration risk, compared to 5%-10% if it were to be included in govvie indices.

The EU has adopted other sovereign-type behaviours in the bond markets, from the way it communicates its issuance plans, the transparency with which it acts in the market, its primary dealer network and the use of both auctions and syndications.

It has also taken various steps to increase liquidity in its bonds, including the launch of its price quoting arrangements at the start of this year, and implementing a repo facility later this year.

The issuer also argues that its legal nature varies significantly from that of a typical supranational or agency issuer: it has a budget-based financial structure — instead of pooled or committed capital — and is ultimately backed by the bloc’s taxpayers. It has certain elements of sovereignty, transferred to it by the member states by treaty, as well as legislative and judicial power, alongside a common currency adopted by 20 member states.

“All of these distinguish us from a typical SSA issuer and bring us closer to the government bond market,” says the official.

That EU bonds require no mutualisation of national debts, as per previous schemes to create a safe asset, could circumvent objections to national governments taking on the liabilities of other member states.

But market participants highlight several obstacles that will keep EU bonds from being recognised and treated as the European safe asset.

Although MSCI and ICE have launched consultations about including EU bonds in their sovereign bond indices, they were still not included, when this GlobalCapital special report went to press in June. And although the volume of EU bonds has swelled in recent years, it is still small compared to major eurozone sovereigns. Germany had €1.85tr of outstanding sovereign securities as of the end of April, according to the Finanzagentur. France had €2.17tr of medium and long term debt outstanding, according to the Agence France Trésor, as of the end of May.

Another concern is whether the EU will sustain this level of issuance. The NextGenerationEU programme that most of its bond issuance funds is intended to run until 2026. The bonds are expected to be repaid by 2058. The debt raised for its pandemic unemployment relief programme is slated to be repaid six years earlier than that. That contrasts with sovereign bond issuance, which is indefinite.

There are fears that this will impact liquidity in the view of passive and active investors and will limit the size of their investment in EU bonds. Investors would be discouraged from treating the debt as a permanent part of their portfolios when developing long-term strategies.

“I don‘t think that the EU bonds can realistically play the role of the longed for European safe asset,” admits a chief economist in Europe.

To be able to do so, the EU would need to issue in greater volumes than it is authorised to. “And it would probably have to be made permanent,” he adds. “As it stands now, its borrowings will have to be unwound by the late 2050s. And if for political reasons — such as joint defence investments — its borrowing perimeter were to increase by multiples, the top-notch rating may well be at risk.

“That aside, I do not see the widespread political support to significantly enlarge the borrowing envelope of the EU but of course, that could change.”

The chief economist is not alone in his scepticism. One senior SSA bond banker says it is “very difficult to imagine” EU bonds developing a similar status in euros to that which Treasuries enjoy in the dollar market. However, he thinks the EU’s claims are not without merit. “Given the size of what the EU has issued and will continue to issue, they are already one of the safe assets,” he adds.

While “many important, small steps” have been taken, he says, substantial progress needs to take place and some question marks to be removed before the EU can serve as the bloc’s common safe asset. “At least one big leap forward will be required to give it some additional impetus,” he adds.

For now the EU is “one of many safe assets”, adds the SSA banker. “And without a doubt, having another European safe asset is helpful for the European market, and there is certainly the potential of the euro market becoming more attractive as a place for global central banks to park their reserves.”

In any case, it is not as if the eurozone’s capital markets do not function even after going through the 2008 financial crisis, the subsequent sovereign debt crisis and then the pandemic. Bonds from the EU — now a large and liquid issuer — are “a nice complement” says the Commission official.

“This diversified market also offers a lot of possibilities,” he says. “Investors have opportunities to invest in each government name, or in the EU as a whole, through EU bonds.”

But for all the Commission’s coyness, other market participants are more strident in their opinion that EU bond issuance at current volumes could become a permanent fixture. When asked whether he thinks it politically viable to have such levels of EU bond issuance permanently, one senior European public sector funding official not at the EU replies: “Of course we can. We are heading in the right direction with the CMU, and we simply need it in order to be more performant as an economy, especially compared to other strong parts of the world like the US and China.

“We need to be more aggregated at the European level, and issuing bonds at the European level was the first step. Having them integrated in global sovereign indices is probably next. But we also need to have more coordinated political decisions at the European level, in order to fund there.”

There is certainly no shortage of demand for the bonds. The average subscription ratio for an EU benchmark syndication is 11.6 times the deal size since 2022, according to data from GlobalCapital’s Primary Market Monitor.

“What we need is politically for the European level to step up to have an agreement and make big decisions,” says the funding official. “And of course, there are challenges and it’ll depend on discussions at the highest level, but we absolutely can make the EU a permanent funding programme.”

The senior SSA banker admits that it is hard to imagine that member states issuers will want the EU to become a single treasury for all of them but he does not discount the possibility that one day it will.

But while the EU’s fragmentation is indeed a hurdle to achieving a genuine single capital market, it is also what makes it unique. “Investors have the choice between direct country exposure or to buy EU debt,” says the SSA banker, “which gives you a much broader exposure to the whole region.”

But that may not last and nor may current thinking about what counts as a safe asset.

“In the global context, we are on the cusp of a seismic shift,” says Katie Kelly, senior director for market practice and regulatory policy at the Icma. “The geopolitical situations and the developments of fintech and AI are affecting the world and what might look like a safe asset today may not be a safe asset in the next two to three decades.

“There needs to be a lot of flexibility and adaptability on what is and what eventually becomes designated as a safe asset.”