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Euro bond proposal threatens an already rattled alliance

The European Commission will soon unveil proposals for a controversial euro zone bond, threatening to divide the troubled region even more.

The EC backed the idea of using euro bonds on Tuesday, bringing some relief to the markets after a punishing run that had sent Italian and Greek bond yields to new highs, hammered European bank shares and triggered a broad selloff in equities. The euro rose against the dollar and European stock indexes climbed.

The EC's support of the plan, which would see the 17 euro zone countries issue debt collectively, came as European officials moved on all fronts to calm markets over a potential default of Greece. German Chancellor Angela Merkel and French President Nicolas Sarkozy said in an emergency teleconference call that Greece is an "integral" part of the euro zone, telling Prime Minister George Papandreou it was vital to follow through on reforms set under a bailout plan in July.

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But an announcement by EC president José Manuel Barroso that he'll soon unveil the bond options promises to be a stumbling block, as Europe scrambles for solutions to its debt crisis. Germany has already opposed the idea, as has outgoing European Central Bank president Jean-Claude Trichet. Mr. Barroso, meanwhile, acknowledged there would be no quick fix. "We must be honest," he said at the European Parliament. "This will not bring an immediate solution to the problems we face and it will come as an element of a comprehensive approach to further economic and political integration."

The proposals come amid signs that financial institutions are increasingly hesitant to lend to European banks. The ECB said it will lend $575-million (U.S.) to two unidentified euro-area banks Thursday, suggesting the banks are finding it difficult to raise U.S. funds in money markets. It is the first time since Aug. 17 that a lender requested U.S. dollars from the ECB.

The euro bond plan would, in essence, merge the safest debt – Germany's – with the junk-rated debt of the weakest countries, such as Greece, Portugal and Ireland. The result would be a bond with a high rating, though perhaps not as high as Germany's triple-A rating. The blended rating would substantially lower the borrowing costs of the bottom-rated countries, though come at a cost to the highest-rated ones.

The euro bond would reflect the collective economic health of the euro zone, not the dire health of the hardest-hit countries. The euro zone's debt-to-gross domestic product is 87 per cent, which is slightly higher than Britain's though lower than that of the United States. According to Deutsche Bank, the euro zone is expected to grow 1.7 per cent this year, the same rate as the United States.

"The joint-and-several guarantee, coupled with robust fiscal rules, would make euro bonds more or less similar to the bonds issued by the most creditworthy entities within Europe," Brockhouse Cooper, a boutique brokerage and consulting firm in Montreal, said in a note on Tuesday.

Some economists and central bankers think the bonds would be a good idea if the euro zone were to move to fiscal unity. Last year, Bank of Italy governor Mario Draghi, now the president-elect of the ECB, said: "Euro bonds could make sense if Europe were not only a currency union, but also a union with a shared tax and budget policy."

Germany is the main obstacle to the euro bonds. Ms. Merkel has always rejected the concept. The bailouts of Greece, Portugal and Ireland have not been popular among German voters because they think those countries were the authors of their own misfortunes. To Germans, a pooling of creditworthiness to create euro bonds would be, in effect, another reward for bad behaviour.

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Popular opinion is not the only problem. It's not clear that the German constitution would approve euro bonds (last week, the German courts said that the three sovereign bailout were legal, but that future bailouts would have to be approved by a budget committee of the German parliament). There is also the question of the fate of the national bonds if euro bonds were introduced.

Euro bonds seem dependent on deep fiscal integration in Europe, a process that could take many years, if it happens at all. Brockhouse Cooper put low odds on their launch. "Europe has far more internal diversity to deal with [than Canada] making the prospect of effective fiscal federalism very remote," the brokerage said.

With files from Bloomberg, Reuters

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About the Author
European Columnist

Eric Reguly is the European columnist for The Globe and Mail and is based in Rome. Since 2007, when he moved to Europe, he has primarily covered economic and financial stories, ranging from the euro zone crisis and the bank bailouts to the rise and fall of Russia's oligarchs and the merger of Fiat and Chrysler. More

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