EU common debt to boost euro’s international role – ECB

Currency still faces negative rates, fragmented debt market and lack of triple-A assets

The European Commission’s first-ever common debt issuance will boost the international role of the euro, says the European Central Bank in its annual report on the currency.

Today (June 2) the ECB stressed how its response to the pandemic – through asset purchases, liquidity support for the banking sector and swap lines with neighbouring central banks – underpinned the currency’s global profile.

The report stresses the importance of the Next Generation EU (NGEU) fund, the €750 billion ($915 billion) stimulus package approved by the European Council in July 2020. This offers grants and loans to member states to finance their post-pandemic recoveries.

Crucially, these funds are issued by the European Commission for the first time, which will create new triple-A euro-denominated assets over the coming years.

The EU’s issuance has gathered “strong interest from investors outside of the euro area”, said the ECB’s executive board member Fabio Panetta in a press conference. “Investors were attracted by shorter maturities; this reflects the stronger presence of investors in this sector.”

In addition to shorter durations, the report says that almost half of the take-up for the 10-year Sure (Support to mitigate Unemployment Risks in an Emergency) bond came from investors located outside the eurozone. “This is comparable to the 10-year bond issued by the European Stability Mechanism (ESM) in 2020,” says the report. Around 20% of investors came from the UK, 9% from Asian countries and 8% from Nordics.

In this context, future NGEU debt issuance is relevant for the euro for two main reasons.

“First, it is a step towards establishing a common European safe asset,” said Panetta. “Second, structural reforms should increase the euro area’s resilience and alleviate market concerns about its fragility.”

Nonetheless, the ECB’s board member acknowledged the NGEU “remains relatively modest in size compared with bond markets in other major currencies”. Additionally, it is “a temporary initiative.” As a result, it is “unlikely at this stage to fundamentally change the global status of the euro”, added Panetta.

ECB’s Covid response

The ECB report highlights how the central bank’s response to the pandemic has ultimately underpinned the currency by quelling fears about its sustainability.

For the first time, the ECB governing council temporarily suspended self-imposed limits on sovereign bond purchases. In March 2020, the council approved the Pandemic Emergency Purchase Programme (PEPP), allowing the ECB to purchase bonds at the rate deemed adequate to bring financing conditions to adequate levels.

The PEPP helped avoid a repetition of the sovereign debt crisis, preventing the increase of the spread between sovereign bond yields in Germany and those of Italy or Spain.

Additionally, the ECB set up liquidity lines with non-eurozone central banks through swap and repo lines. “By ensuring that euro funding is available to counterparties outside the euro area, the Eurosystem’s swap and repo agreements help the ECB fulfil its monetary policy objectives,” says the report.

“In particular, they prevent euro liquidity shortages from morphing into financial stability risks, avoiding forced asset sales and negative spillback effects stemming from the use of the euro by non-euro-area residents as a funding or investment currency.”

The ECB established these lines with the central banks of Albania, Croatia, Hungary, the Republic of North Macedonia, Romania, San Marino and Serbia. Currently, they are scheduled to expire in March 2022.

Structural deficiencies

In spite of the progress it has made during the last few years in addressing fragmentation risks, the eurozone still suffers from structural weaknesses.

Although the European Commission will issue collective debt, it is far from a common Treasury. Sovereign debt markets in the eurozone are fragmented along the borders of its 19 member states. This hampers the development of a deep and liquid capital market that could rival the US Treasury market.

To put the NGEU’s impact in perspective, the report estimates it will increase eurozone triple-A sovereign bonds by 40% over the next years, from the current level of €2.2 trillion. In the US, outstanding general government debt securities hovers around $24 trillion, all of it triple A. Total eurozone government debt securities are below $13 trillion.

This has a direct impact on the euro’s presence in global capital markets. In 2020, US dollar-denominated securities represented over 70% of the securities included in the Bloomberg Barclays Global Aggregate – Aaa index, a global market benchmark for safe bonds, according to the report. In contrast, euro-denominated securities stood at just 16%.

This is partly the legacy of the 2010–12 sovereign debt crisis, when rating agencies downgraded the government debt of several eurozone economies.

The dollar dominance in this respect is unlikely to weaken in the years ahead. “The size of planned EU bond issuances will not fundamentally alter the relative currency shares in the supply of global safe bonds,” says the report. “And so far, EU bonds have not been included in the sovereign segment of broad bond indices.”

Stable as a reserve currency

During 2020, the share of the euro in international reserves portfolios remained broadly unchanged.

The currency stood at 21% of foreign exchange reserves, while the US dollar finished the year at 59%. In terms of total international debt, it accounted for around 23% of outstanding international debt securities, while the dollar reached 63%.

In this area, the euro encounters another challenge. Most reserve managers cannot add negative-yielding assets to their official portfolios. On average, eurozone five-year government bond yields stood at -0.6% in 2020, while the one-month deposit rate hovered around -0.5%. By contrast, the US five-year government bond yield and the one-month deposit rate both averaged around 0.5%.

Additionally, some reserve managers cannot hold debt from countries lacking a triple-A rating. As a result, they shy away from a currency that could potentially offer diversification benefits as an alternative to the dollar.

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