Soaring Pandemic-Driven Eurozone Borrowing Reignites Debt Forgiveness as ‘Working Hypothesis'

Amid skyrocketing borrowing by Eurozone governments triggered by the coronavirus pandemic, calls have been reignited for the European Central Bank (ECB) to cancel the sovereign bonds it holds, thus easing the debt burden, writes Financial Times.

The idea in itself is not new. Previously, the proposal was floated by economists when the single currency area faced a financial and sovereign debt crisis in 2012.

At the time, debt ratios in the eurozone soared from 65.9 percent of GDP in 2007 to around 93 percent of GDP five years later. By the end of 2019, the ratio had steadied, declining to 87 percent of GDP, with academic economists underscoring how hard it was to return government debt to pre-crisis levels.

As the COVID-19 pandemic continues to impact the global economy, senior Italian officials recently re-embraced the idea of the ECB forgiving debt bought through its asset purchase programme. As another option, the debt might be exchanged for perpetual bonds, or bond with no maturity date, which are never repaid.

Perpetual bonds are, in effect, a debt obligation in name only, as the issuer is not required to repay the debt as long as they continue making the interest (coupon) payments due to bondholders.

With governments seeking to address the challenges of the ongoing health crisis, responses to the pandemic are anticipated to rack up €1.5 trillion of extra debt.

Many countries are currently registering budget deficits above 10 percent of the gross domestic product (GDP), including Italy, France and Spain.

By 2021 Italy’s government debt is expected to rise from 135 percent of GDP last year to almost 160 percent.

Accordingly, for the first time, analytics suggest the eurozone’s sovereign debt may soar above the size of the bloc’s economy this year.

‘Debt Forgiveness’

The European Commission fiscal rules require governments to maintain deficits below 3 percent of GDP and overall debt under 60 percent of GDP.

​Due to the coronavirus pandemic, the European Union rules setting limits on government borrowing were suspended, and will remain so in 2021, Economic Commissioner Paolo Gentiloni told a news conference on 5 October after a meeting of euro zone finance ministers.

However, they are likely to be reactivated in some form once the crisis is over, with governments finding themselves under pressure to deleverage, writes the outlet.

In November, David Sassoli, the Italian president of the European Parliament, was quoted by La Repubblica as saying that debt forgiveness was “an interesting working hypothesis, to be reconciled with the cardinal principle of debt sustainability”.

​Riccardo Fraccaro, a senior aide to Italian prime minister Guiseppe Conte, was cited by Bloomberg as urging that “monetary policy must support member states’ expansionary fiscal policies in every possible way”.

According to him, this could include “cancelling sovereign bonds bought during the pandemic or perpetually extending their maturity”.

So far investors have not weighed in on the issue, as the cost of new debt remains low. The ECB acquires most of the extra bonds sold, enabling many countries to borrow for up to 10 years at yields of close to or below zero.

For the time being, the ECB is expected to extend bond-buying until mid-2022.

“There are so many reasons not to be concerned by rising debt levels at the moment, but in the future we will need to have this discussion at some point,” said Carsten Brzeski, economist at ING.

He added:

“Some kind of debt forgiveness may be needed, whether it is done directly by the ECB, or by swapping debt into perpetual bonds with a zero interest rate.”

‘Dangerous, Destabilising’

The option of debt forgiveness has been dismissed by central bankers as “dangerous” and “destabilising”.
Economists similarly reject it, as counterproductive.

“We have to distinguish the political position from the economic position. From the purely economic perspective debt relief could make sense in some circumstances, but it depends on how you do it. From a political point of view, it is extremely dangerous. So it seems extremely unproductive to raise it now,” said Lucrezia Reichlin, economics professor at London Business School.

Chief economist at Hamburg-based Berenberg Bank, Holger Schmieding, slammed the floated proposal as “the worst idea of the year” which “could backfire badly” , scaring off investors and driving up borrowing costs.

Furthermore, cancelling government debt is suggested as most likely representing a breach of the EU treaty’s ban on the monetary financing of governments. This fact was made clear by ECB President Christine Lagarde.

​When questioned on the matter during a European Parliament discussion in November, she responded by saying “ I don’t even ask myself the question – it’s as simple as that – because anything along those lines would simply be a violation” of the law.

In April, Lagarde dismissed the possibility of a generalised cancellation of debts contracted during the coronavirus crisis as “totally unthinkable”.

“It’s not the right time to ask the cancellation question, right now we are concentrated on keeping the economy going,” Lagarde said in an interview on France Inter radio, adding:

“Later we will look at how to pay down the debt and how we manage public finances in the most efficient way,” she added.

‘Technical Wrinkles’

The idea of debt cancellation in the eurozone is linked with several difficulties, writes the outlet.

While in theory, central banks are able to absorb losses, capitalising on the ability to print more money, in the Eurozone national central banks buy most of their governments’ bonds on behalf of the ECB.

Thus, if bonds were cancelled, these national central banks would be facing losses without being able to print money themselves, forcing governments to recapitalise them or risk them being shut out from the bloc’s payments system.

The idea of debt cancellation was dismissed by the Italian government on Friday, as Vincenzo Amendola, Italy’s minister for European affairs, was cited by Bloomberg as underscoring that his country “honours its debts”.

He added:

“We work with current treaties, and with current treaties this is not possible.”