Fund Strategy, November 2010 – “Single currency, many differences”

Unlike sterling, which is backed by Britain’s bullion and currency reserves and tax receipts, the political risk around the euro is a Venn diagram of European central banks and nation states.

The “alteration to the euro rules” brokered by Angela Merkel, the German chancellor, aims to ensure that holders of sovereign debt bonds will experience a partial loss of principal if there is a bail-out of a eurozone member state. Her aim is to reassure voters that Germany will not underwrite the sovereign debts of other eurozone countries under the guise of an operation to protect the currency itself. There were no rules to be altered: Chancellor Merkel has merely clarified the situation and at the same time, the fault lines at the heart of the euro as a currency.

On the one hand, a euro-denominated sovereign obligation is as good as the underlying nation’s ability to produce euro out of its own economy. There is no sharing of liability between the euro countries just because they share the currency in which the bonds are denominated. A euro obligation ofBritain orDenmark has no different status just because these countries have a different legal tender for daily use, namely pound and kroner.

”Being responsible for note and coin does not mean that a eurozone central bank may produce the currency of its nation state, to cover the nation’s spending deficit”

On the other hand, there is a joint underwriting of the legal tender aspect: euro note and coin are issued under joint and several liability by the European System of Central Banks – each of which is owned by its nation state. The true nature of the responsibility is obfuscated in the notes’ appearance – the coins have national characteristics, while euro notes are identical. The notes bear no clarifying words, just the abbreviation “ECB” and the word “euro”. Compare this with the pound – whose notes have the words “Bank of England I promise to pay the bearer on demand the sum of [n] pounds” and are signed “Andrew Bailey, chief cashier”.

Being responsible for note and coin does not mean, though, that a eurozone central bank may produce the currency of its nation state, to cover the nation’s spending deficit. This is a role of a sovereign central bank, where the responsibility for the sovereign’s debts in its own currency and the production of the currency itself meet.

That link is broken in the euro, so the nation state itself stands or falls on its own. Sovereign obligations in euro are several and not joint, notwithstanding the policy measures aimed at a convergence of the euro economies to a point where relative sovereign risk would be eliminated. First the Exchange Rate Mechanism to squeeze out exchange rate fluctuations. Second theMaastrichtcriteria, aimed at convergence of inflation, interest rates and public debt. Third the Stability and Growth Pact, to control budget deficits and government debt after euro adoption.

Euro members progressively handed over control of ­foreign exchange and monetary policy, those being the main levers of a sovereign central bank, to European Union (EU) institutions along with monopoly control over the supply and production of the state’s currency. But it is not a complete handover.

The partial handover and centralisation of euro-related roles and powers has confused who is on the hook to pay as primary and secondary obligors, a situation that has benefited the euro and its weaker members.

Contrast the situation in Britain where the Bank of England issues note and coin, and is owned by the government, and the government’s debts are backed by Britain’s bullion and currency reserves and a look-through to the tax-paying capacity of all entities that use the pound as legal tender. The country and its currency represent the same political risk.

The central banking and thus the political risk around the euro are by contrast a Venn diagram of respective powers and resources of the: EU nation states; eurozone nation states; European Central Bank (ECB); the European System of Central Banks, or eurosystem – the ECB and all the National Central Banks (NCBs) of the whole EU; the eurozone NCBs – a ­subset of the eurosystem; and the non-eurozone NCBs – the other subset of the eurosystem.




While the NCBs are presented as branches of the ECB, they have an autonomous and sovereign status in national law and are owned by their nation state.

A situation where all eurozone NCBs have equal and shared liability to pay out would indicate a real currency, if the backing for it was also shared. It is not, though: the bullion and currency reserves backing the euro are owned by the eurozone NCBs, not by the ECB. Similarly, these reserves back the debts of each eurozone sovereign severally: there is no pooling.

Curiously, a eurozone NCB’s reserves back both the note and coin on a joint and several basis, and its nation’s sovereign debts on a several but not joint basis. This is asymmetrical but has led to sovereign debts enjoying lower yields than the economic performance of their country
has justified.

This has all changed. The bund spread illuminates both the differences in economic performance and the understandable propensity of the capital markets to look through the currency of a debt to each sovereign’s ability to pay, and to look past any policy measures that were aimed at economic convergence superseding the issue of variations in creditworthiness.

Link to Fund Stategy article, November 2010