Soaring eurozone government debt reignites call for cancellation

Soaring eurozone government debt reignites call for cancellation

Eurozone governments’ borrowing has rocketed to fund their response to the coronavirus pandemic, reigniting longstanding calls for the European Central Bank to ease debt burdens by forgiving sovereign bonds it owns.

The proposal was floated by academic economists as an answer to the single currency area’s last debt crisis in 2012. Senior Italian officials have recently stirred up the idea once more, suggesting the ECB could forgive debt bought through its asset purchase programme or swap it for perpetual bonds, which are never repaid.

Governments’ responses to the pandemic will rack up €1.5tn of extra debt, pushing the eurozone’s sovereign debt above the size of the bloc’s economy this year for the first time. Many countries are running budget deficits above 10 per cent of gross domestic product, including Italy, France and Spain. Italy’s government debt is expected to rise from 135 per cent of GDP last year to almost 160 per cent in 2021. 

While the EU’s fiscal rules — requiring governments to keep deficits below 3 per cent of GDP and overall debt under 60 per cent of GDP — have been suspended since the pandemic hit, they are likely to be reactivated in some form once the crisis is over, piling pressure on governments to deleverage.

David Sassoli, the Italian president of the European Parliament, told La Repubblica last month 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, followed up by telling Bloomberg that “monetary policy must support member states’ expansionary fiscal policies in every possible way”. That could include “cancelling sovereign bonds bought during the pandemic or perpetually extending their maturity”, he said.

So far investors have not added to the clamour — the cost of new debt remains low as the ECB buys most of the extra bonds sold, so many countries are able to borrow for up to 10 years at yields of close to or below zero. That is set to continue; at its latest policy meeting on Thursday 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. “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.”

But central bankers have rejected the idea as “dangerous” and “destabilising” while economists dismiss it as counterproductive and poorly timed.

Line chart of Spread between German 10-year bond yield and that of other government (% points) showing ECB interventions help keep funding costs low across the eurozone

“We have to distinguish the political position from the economic position,” said Lucrezia Reichlin, economics professor at London Business School. “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.”

Holger Schmieding, chief economist at Berenberg, said it was “the worst idea of the year” as it “could backfire badly” by spooking investors, causing borrowing costs to rise. 

In any case, cancelling government debt would almost certainly breach the EU treaty’s ban on monetary financing of governments, as ECB president Christine Lagarde made clear when asked about the idea in a European Parliament discussion last month.

Her fellow ECB governing council member and Banque de France governor François Villeroy de Galhau agreed, saying: “To consider debt cancellation would be a very dangerous path.”

Bar chart of Government debt, by holder (€tn) showing The ECB holds a large amount of eurozone government debt

Fabio Panetta, the former Italian central bank deputy governor who joined the ECB board in January, said: “If we cancel a debt, we cancel the corresponding credit and this could have broader, destabilising consequences. Only growth can protect us from debt.”

There is also a technical problem with the idea. While central banks can in theory absorb losses and tolerate negative equity thanks to their ability to print more money, the situation in the eurozone is more complicated. 

National central banks buy most of their governments’ bonds on behalf of the ECB. If the bonds were written off or cancelled it would leave the national central banks nursing losses, without being able to print money themselves. Their governments might then need to recapitalise them or risk them being shut out from the bloc’s payments system.

Another wrinkle is that governments already recoup most of the interest they pay on bonds owned by the ECB — via dividends from their national central banks — so they would not save much money from debt cancellation in the short term; the only benefit is not having to repay the debt.

But as long as the ECB keeps reinvesting the proceeds of maturing bonds in its portfolio, governments can simply roll over this debt. 

“Where is the gain?” said Volker Wieland, a professor at the Institute for Monetary and Financial Stability in Frankfurt. “Only at some point in the future when the ECB stops reinvesting money from maturing bonds, and that is very far in the future.”

Because of this, he said advocates of debt cancellation were “really shooting themselves in the foot”.

The idea has also met opposition within the Italian government. On Friday, Vincenzo Amendola, Italy’s minister for European affairs, told Bloomberg the country “honours its debts”, adding: “We work with current treaties, and with current treaties this is not possible.”

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