The European Union is grappling with escalating debt credibility concerns as borrowing costs soar and yield spreads widen.
To regain investor confidence and narrow the gap between its jointly issued bonds and those of France, the EU must make good on revenue-raising promises and shift investor mindsets.
EU borrowing costs have skyrocketed from 0.14% in 2021 to 2.6% in the second half of 2022, with further increases anticipated. As of April’s end, the union had outstanding bonds worth €381 billion, and the rising costs are taking a toll on the union’s financial health.
Doubts over the EU as a sovereign borrower
Despite being rated AAA by Fitch and Moody’s and AA-plus by S&P, higher than France, the EU is paying more because markets have not accepted Brussels as a sovereign borrower.
The union’s debt trades as a supranational institution, not a country, leaving it out of government bond indexes and portfolio allocations. Inclusion in these benchmarks would encourage asset managers to sell French bonds and buy EU bonds, earning extra yield on similarly rated sovereign debt.
The European Commission’s efforts to change its debt classification have not gained traction, despite the European Central Bank’s support, which upgraded the debt to its top tier of monetary policy collateral last year.
Market participants, like LBBW Chief Economist Moritz Kraemer, argue that the euro area has yet to demonstrate its political commitment to unity. Critics point to the temporary nature of the pandemic borrowing program and the common currency’s near-collapse during the 2010-2015 crisis.
The need for new revenue sources
This skepticism has led to market participants pricing in a future lack of liquidity, even though there is an abundance of well-managed debt available for trading.
Other reserve currency safe assets, such as U.S. Treasury bonds or Japanese debt, do not face prospective supply cuts. Moreover, the union has made commitments to repay its obligations with new revenue sources, like digital and carbon taxes, that have not yet materialized.
While the union’s general budget can manage the increase in debt costs using existing measures, political leaders must become more comfortable with joint debt and promote the € as a reserve currency.
To achieve this, Brussels needs to persuade member states to deliver on promised new revenues. Failure to do so could result in pan-European bonds becoming a symbol of the euro countries’ reluctance to fully integrate, much like the unfinished banking union.
Rising administrative costs
In 2023, the EU is expected to face a new layer of administrative costs as interest earned on held funds no longer offsets rising borrowing rates.
The Union became a significant bond market player in 2020, pledging to borrow approximately €900 billion on public markets to support the NextGenerationEU recovery program and a related unemployment initiative.
Although net new borrowing for pandemic programs is scheduled to end in 2026, the union will maintain a substantial market presence managing its existing portfolio and borrowing to support aid to Ukraine and other objectives.
As the EU struggles to restore debt credibility amid a worsening crisis, delivering on new revenue sources and shifting investor mindsets will be crucial for future financial stability.
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