Splitting sovereign debt could help save euro zone

Introducing a system of blue and red bonds, representing senior and junior debt, in the euro zone may be one way of helping each individual country to remain in the black.

BRUSSELS // Financial markets almost succeeded in breaking up the euro zone. So the idea of harnessing the power of the market and of financial engineering to guarantee the euro's long-term viability might seem paradoxical. But this is precisely what our proposal to split euro-zone sovereign debt into senior and junior tranches aims to achieve.

The senior tranches would comprise debt totalling up to 60 per cent of the GDP of each participating country. These countries would then pool this debt and issue a joint and several guarantee. The resulting "blue bond" (named after the colour of the European flag) would be an extremely safe and highly liquid asset, comparable in volume to US treasuries, thereby helping the euro's rise as an international reserve currency and ensuring low refinancing costs for the bulk of euro-zone debt.

By contrast, any debt beyond 60 per cent of GDP would have to be issued as junior "red bonds" under purely national responsibility. These "red bonds" would make borrowing beyond 60 per cent of GDP more expensive, thereby enhancing fiscal discipline and reinforcing the targets set by the stability and growth pact. Moreover, "red bonds" could be conveniently ring-fenced so that they do not destabilise the banking system. This would ensure the no-bailout clause that applies to them becomes a credible proposition. For example, the European Central Bank should exclude "red bonds" from its repo facility and a standardised collective-action clause to facilitate debt rescheduling should be made mandatory for these bonds.

If implemented successfully, our proposal would lower the costs of debt service while strengthening the incentives for individual countries to pursue fiscally responsible policies. This is what distinguishes our proposal from suggestions that all euro-zone debt be pooled in euro bonds in a spirit of solidarity. But successful implementation of this plan requires a rock-solid governance structure that markets and taxpayers in the most stability-oriented euro-zone countries can trust.

That is why we believe that the annual allocation of "blue bond" emissions should be delegated to an independent stability council. The council would offer a take-it-or-leave-it proposal to the participating countries on the allocation of "blue bonds" for the coming year. Each national parliament would then adopt the proposal, given participating countries a role in providing the guarantees implied by that allocation.

Within this mechanism, countries that pursued reckless fiscal policies could be gradually excluded from the system by lowering their "blue bond" allocation. And countries unhappy with the system's evolution could gradually exit it simply by rejecting their annual "blue bond" allocation for a sufficient number of consecutive years. They would no longer issue or guarantee "blue bonds". The "blue bond" scheme is compatible with the no-bailout clause in Article 125 of the EU Treaty, because the debt guarantee would apply only to senior debt amounting at most to 60 per cent of GDP, the level that the Maastricht Treaty deems sustainable for any EU member state. Therefore, the guarantee would not apply to debt crises caused by excessive borrowing to finance unsustainable fiscal policies.

The ultimate test for our proposal is whether the euro-zone countries - their confidence shaken by the debt crisis - have an interest in coming together and participating in this voluntary scheme. We believe they might. First, smaller countries with relatively illiquid sovereign bonds stand to benefit substantially from the extra liquidity provided by the "blue bond". Second, countries with high debt levels would welcome this opportunity to control borrowing costs and to commit to stronger fiscal discipline after the current crisis.

But the countries that stand to gain the most from the scheme's promise of strengthened fiscal discipline are those that worry most about having to foot the bill for sovereign bailouts - now and in the future. Jacques Delpla is an adviser at the Conseil d'Analyse Economique in Paris. Jakob von Weizsacker is a research fellow at Bruegel, a Brussels-based think tank. Project Syndicate