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Euro Bonds Stoke Tempers as Debt Market Flashpoint: Euro Credit

A proposal to sell joint euro-region debt has emerged as a new flashpoint among European leaders running out of options to stabilize bond markets.

With a European Union summit set for next week in Brussels, officials from Italy, Luxembourg, Belgium and Greece said the proposal should be explored, prompting resistance from Germany, France and Austria. Economists and analysts from Goldman Sachs Group Inc., Morgan Stanley and HSBC Holdings Plc said it may end the euro-region debt crisis.

The plan would establish a European Debt Agency to sell bonds to finance as much as 50 percent of EU member borrowing, climbing to as much as 100 percent for countries unable to lure investors. Opponents say the proposal would raise interest rates for stronger nations. The weighted-average five-year borrowing cost for the 16 euro-region nations was 3.05 percent yesterday, compared with 1.95 percent on German debt, data compiled by Bloomberg show.

“It’s very important that negotiations continue on the path of some kind common bond issuance and a more centralized fiscal policy,” said Steven Major, global head of fixed-income research at London-based HSBC. “We can’t go on like this with the ECB doing the heavy lifting. We need a more sustainable solution.”

A joint euro bond may be the first time one country has issued debt on behalf of another. In 1989, so-called Brady bonds were issued by nations, including Colombia, Brazil and Venezuela, backed by the U.S. government. The bonds are named after former Treasury Secretary Nicholas Brady, who helped create the program.

Credit Agricole

The European Financial Stability Facility, the 440 billion-euro bailout fund set up by the EU after the Greece rescue, plans to sell bonds in January to pay for aid to Ireland. While backed by most of the same nations that would be involved in a euro bond, it has attracted a AAA rating through a number of credit enhancements and would therefore likely attract lower yields than a euro bond, according to analysts at Credit Agricole Corporate & Investment Bank.

Politicians are tabling ideas to tackle the euro-region’s fiscal crisis after the European Central Bank was forced to step up its buying of government bonds when a bailout of Ireland last month failed to defend the region’s bond markets against investors betting on a breakup of the euro.

Irish bonds fell after the nation said Nov. 21 that it had asked for a bailout, with the 10-year yield reaching a record 680 basis points more than benchmark German bunds on Nov. 30. Yields have declined since the ECB stepped up purchases of bonds from Ireland, Portugal and Greece on Dec. 1, reducing the Irish-German spread to 503 basis points yesterday.

‘Intellectually Attractive’

Luxembourg Prime Minister Jean-Claude Juncker and Italian Finance Minister Giulio Tremonti put forward a plan for selling joint bonds in a Financial Times commentary on Dec. 6, heightening the current debate. The idea is “intellectually attractive,” EU Economic and Monetary Affairs Commissioner Olli Rehn said the same day, while Greek Prime Minister George Papandreou said it’s time to “seriously discuss” it.

Juncker, who chairs meetings of euro-group finance ministers, took a swipe at the German opposition, prompting a riposte from a key ally of German Chancellor Angela Merkel.

Germany rejected his proposal to create euro-region bonds too quickly and has shown “simple” thinking on the matter, Juncker said on Dec. 8, Die Zeit reported citing an interview. Germany is dealing with European matters “in an unEuropean way” and the bond proposal was dismissed before Germany had examined it properly, the German newspaper cited him as saying.

The Debate

Michael Meister, the senior finance and economy spokesman for Merkel’s Christian Democratic bloc, shot back in an interview later that day.

“We can’t put any more on the table,” Meister said in an interview. Juncker and Tremonti “can surely say what they want. They can go ahead with joint bonds if they want,” he said.

The objections may not be final, Major said. Merkel opposed bilateral loans to Greece on the same grounds, before joining euro-region nations and the International Monetary Fund in providing 110 billion euros of loans to the debt-stricken nation. Merkel also backs a change in the European Union treaty that allows for the creation of a permanent crisis mechanism.

Merkel’s stance is “a negotiating position,” Major said. “The worst-case scenario would be more expensive for Germany” than issuing common bonds, he said.

Euro Falls

The euro fell against most of its major counterparts today and yields on Spanish and Italian bonds jumped as leaders from Germany and France said they are against increasing the EU’s 440 billion-euro rescue fund and rejected joint euro-area bonds.

“Common bonds would make governments less responsible, when what we want to do is the opposite,” French President Nicolas Sarkozy told reporters after meeting with Merkel today in the southern German city of Freiburg.

The creation of common bonds or bills for the euro area may help bring an end to the region’s fiscal crisis by deepening market liquidity, according to Sander Schol, a London-based director at the Association for Financial Markets in Europe.

The AFME’s European Prime Dealers Association wrote a research paper for the European Parliament on the potential for a common European Issuance Program. It found “smaller liquidity premiums, more effective hedging and the removal of the market-making obligation would lead to lower interest rates,” Schol said.

‘Optimal Risk Sharing’

Such bonds might be the “optimal risk-sharing scheme,” Goldman Sachs rate strategist Francesco Garzarelli and economist Natacha Valla said yesterday. Designed correctly, a joint bond program would create a financial incentive for fiscal prudence and reduce moral hazard, Arnaud Mares, an executive director at Morgan Stanley and former senior vice president at Moody’s Investors Service, said on Dec. 6.

Compelling theory is unlikely to bring the plan to fruition anytime soon, according to said Michael Leister, a fixed-income analyst at WestLB AG in Dusseldorf.

“For Germany or France it wouldn’t be at all attractive, because they would end up paying a higher yield,” he said. “This isn’t a concept you can sell to the German electorate right now, and probably the same in Austria and France.”

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