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Merkel in pickle after 'Germany bond' concession

FRANKFURT (MarketWatch) -- Chancellor Angela Merkel's decision to back a debt-sharing plan by Germany's federal and state governments could come back to haunt her as she attempts to hold a hard line against calls for joint issuance of euro-zone debt when she meets with fellow leaders of the currency bloc in a summit later this week, economists said.

Merkel over the weekend reversed her opposition to allowing state governments to share borrowing costs with the federal government through the issuance of so-called Germany bonds. The chancellor agreed to the demand by Germany's Social Democrats and other opposition parties in order to secure parliamentary approval of the European Union fiscal pact.

But some observers said the reversal could make it more difficult for Merkel to maintain a hard line against calls for a similar debt-sharing exercise at the euro level.

"She will be accused of a 'Deutschland Erster' (Germany First) approach" after signaling a rejection of joint euro-zone debt as recently as Saturday, when she insisted "liabilities and controls" must go together, said Stephen Pope, managing director of Spotlight Ideas in London, in emailed comments.

Berlin disagrees. German government spokesman Steffen Seibert told reporters Monday that Germany bonds, which will be launched next year, won't serve as a model for euro bonds, Dow Jones Newswires reported.

"This is not a euro idea, Seibert said.

Strategists noted, however, that Merkel's opposition to so-called Deutschland bonds was based on the same principle as her opposition to euro bonds.

"The chief argument, as is the case in the current debate about euro bonds, has always been 'moral hazard'," said Peter Schaffrik, strategist at RBC Capital Markets in London.

In other words, German states or euro-zone countries will be less inclined to get their public finances in order if they have the opportunity to lower their borrowing costs by effectively sharing their debt burden with more fiscally sound partners, such as the German government.

For Berlin, shared debt issuance across the euro zone can only come after much tighter fiscal integration.

Merkel's "opposition to euro bonds is based on the lack of fiscal integration, which needs to be achieved first. As German states will surrender some of their budget autonomy in the fiscal compact, this precondition will be met," said strategists at Commerzbank.

Still, some see the retreat on Deutschland bonds as a sign Berlin's resolve may be weakening.

Schaffrik said it must be assumed that complex rules will be put in place regulating which German states will be eligible for funding and at what cost.

"We believe that these guidelines will make an interesting yardstick for a future European rule book," he said, in a research note. "Besides, we also argue that the sheer development alone suggest that there is a major sea-change under way in how the German government addresses these problems: Instead of an outright 'nein' a constructive outcome is now apparently possible."

If nothing else, the move could tarnish the German bund market's safe-haven allure, analysts said.

Bund yields have declined to record lows in recent weeks as renewed fears over the euro zone crisis sparked safe-haven flows. Two-year yields fell into negative territory in late May before rebounding back above zero.

Increased bund supply "will further reduce the safety/scarcity value embedded in bunds," wrote strategists at Commerzbank, in a research note. "Unlike some earlier proposals, the plan not only includes joint issuance among all states but also together with the federal government. Thus it could mark a sea-change for the bund market."

Bunds weren't suffering Monday, however, amid rising skepticism over prospects for a breakthrough in this week's European Union summit.

The yield on the 10-year instrument (10YR_GER) fell 0.09 percentage point to 1.49%, according to electronic trading platform Tradeweb. Yields fall as bond prices rise.

Peripheral euro-zone government bond yields were on the rise, meanwhile, with analysts citing diminishing prospects for an agreement on a plan to decisively tackle the region's long-running debt crisis when European Union leaders meet on Thursday and Friday.

The euro (EURUSD) traded at$1.2498, down from $1.2564 in North American trade late Friday. Read Currencies.