Saturday, September 24, 2011

Eurobonds and Modigliani-Miller (ls)

Economists tend to be skeptical towards Eurobonds for various reasons. See for instance the reflections of Daniel Gros here. I would like to add another argument: I make the point that Eurobonds won't bring down the weighted average capital costs of the periphery countries to a heavy extent. Why?

Consider the introduction of two types of bonds: There are jointly guaranteed blue bonds, which each country can use to finance its debt up to a certain threshold (e.g. the Maastricht criterion). If a country is running higher debt levels, it has to finance them via country-specific red bonds. There is no joint guarantee on them, and they are by construction subordinated.

A country with under-average credit quality might consequently be able to conduct a part of its financing cheaper via blue bonds. But the residual debt has to be financed by red bonds. Obviously, investors will demand extremely high yields, due to the lack of joint guarantee and - most importantly - due to subordination. Hence, the averaged costs of debt services remain the same. This is in fact Modigliani-Miller in its essence. Changing the capital structure doesn't affect average capital costs.

Admittedly, this is not a perfect MM-world, since we introduce some type of exogenous guarantee mechanisms. This will indeed bring the average capital costs down, since the core countries lend some creditworthiness to the periphery. But these effect will probably be of a much smaller magnitude than expected, due to the mechanism described above.