The Eurozone, which was deeply mired in the European debt crisis for years, is once again in the spotlight due to rising debt concerns. EU officials estimate that by the end of 2026, the EU's debt will reach 900 billion euros.
On October 11, media reports indicated that EU government officials stated that the EU's current debt has rapidly grown from a low base, becoming a "real player" in the bond market. Due to the "Next Generation EU" initiative, the EU's debt issuance has surged from about 50 billion euros in 2020 to 450 billion euros. This figure is expected to exceed 500 billion euros by 2024, making it the fifth-largest debtor in the EU.
Analysts point out that most of the EU's debt comes from the "Next Generation EU" initiative. The funds from this program are intended to support the EU's economic recovery and development post-pandemic. According to the agreement, the EU will establish a recovery fund of 750 billion euros, of which 390 billion euros will be direct grants, and the remaining 360 billion euros will be loans to help EU member states recover economically.
The EU plans to issue bonds between 2021 and 2026, raising 150 to 200 billion euros annually. Repayments will begin in 2028, with all bonds to be repaid by the end of 2058.
Rohan Khanna, the Euro rate strategy head at Barclays, raised a significant question: Is the bond issuance by "Next Generation EU" a one-time event, or has this coordinated fiscal policy become the new norm?
Who's Buying EU Debt?
Analysts highlight a challenge with the EU's large-scale bond issuance: Investors expect higher returns from EU bonds than from individual EU country bonds. Although the EU has an AAA credit rating (higher than France's AA rating), the yield on the EU's 10-year benchmark bond is 3.6%, compared to Germany's 10-year bond yield of 2.8% and France's 3.4%.
Clearly, national bonds from Germany and France are more attractive than EU bonds.
Some investors have also expressed concerns about the limited liquidity of EU bonds due to their relatively smaller free-trading volume, resulting in higher trading costs. Additionally, EU bonds have not been included in sovereign bond indices, making them less appealing to many investors whose strategies align with these indices.
Andres Sanchez Balcazar, Pictet's global bond chief, pondered whether the EU intends to use bond issuance for infrastructure financing as a way to have a shared budget, making the EU more like a single nation. However, it remains unclear whether there's political will among member states to move in this direction.
Rising Interest Rates Amplify Default Risks
As the EU issues bonds on a large scale, the European Central Bank (ECB) has implemented multiple rounds of interest rate hikes over the past year, pushing up borrowing costs and breeding default risks.
Since initiating rate hikes last July, the ECB has raised rates ten times, accumulating a 450 basis point increase. Analysts generally believe that these moves by the ECB will further restrict economic activity in the Eurozone, adding to its economic woes.
According to data from the EU's statistical office, the Eurozone's core harmonized CPI in September dropped to a year-low of 4.5%, still significantly above the ECB's 2% target.
The ECB's successive rate hikes have not only failed to bring inflation down to target levels but have also dampened economic growth momentum. The risk of stagflation is rising, with the Eurozone's Q2 GDP revised down from 0.3% to 0.1%.
Furthermore, rising interest rates mean higher borrowing costs, limiting government spending and challenging the debt repayment capabilities and creditworthiness of debtor nations. A debt default could have profoundly negative implications for the international financial market, impacting both the defaulting nation and the entire Eurozone.
It's worth noting that the EU must start repaying the "Next Generation EU" debt from 2028. EU Budget Commissioner Johannes Hahn stated in August that due to rising interest rates, interest payments will reach 4 billion euros by 2024, nearly double the previous estimate of 2.1 billion euros.
To address the higher costs resulting from rising interest rates, the European Commission faces a daunting political task of requesting more funds from member states during ongoing budget discussions. A European diplomat remarked:
"EU finance ministers have to push for tough budget cuts domestically to offset the burden of rising interest rates. Asking them to fork out billions of euros, just to spare the Commission from making similar tough choices, is politically unrealistic."
