Alongside last week’s unveiling of support for Ireland, the euro group announced the broad outline of a permanent plan, the European Stability Mechanism (ESM), for dealing with future debt crises.
Two aspects of the announcement stand out: it takes at most a wobbly step toward the professed goal of creating a mechanism for restructuring sovereign debt to private creditors; and the timing underscores that German taxpayers’ tolerance for bail-outs—whether in response to banking crises (Ireland) or fiscal crises (Greece)—is badly frayed. Thomas Mayer, chief economist for Deutsche Bank, warns of a possible Tea-Party style grass roots movement in Germany against euro-zone bail-outs.
Germany has taken flak from commentators around the world for pushing the plan at a time of unusual market stress. Indeed, the timing of this announcement is sub-optimal (it should have been done with the introduction of the common currency). But the need for a debt restructuring mechanism in a currency union like the Euro area is patent. For even if the importance of a formal mechanism to ensure orderly procedures for restructuring is debatable, it is hard to argue that a currency union without adequate disciplining powers over fiscal profligacy can survive without a credible threat of restructuring. Unfortunately, last week’s announcement goes only a small step toward establishing such a threat.
What is on the table?
When a country faces severe market stress, the IMF, European Commission, and European Central Bank will assess whether it is “insolvent” and “On this basis, the Euro group Ministers will take a unanimous decision on providing assistance.” For solvent governments, creditors would be “encouraged to maintain their exposure.” Funding would presumably also come from the ESM (which will have permanent funding of an as yet undisclosed amount) and the IMF. For insolvent governments, a restructuring of debt to private creditors would be negotiated. The ESM and IMF might also provide funds.
Collective action clauses (CACs), which allow revisions to a bond contract if supported by a qualified majority of the bond’s holders, will be included in bonds issued by euro area governments from June 2013. Although CACs have been common in emerging market loan contracts since 2004, most European countries, which saw themselves in a different asset class from emerging markets, have not followed suit.
Going from this to a credible mechanism for restructuring private loans to European sovereigns in debt crises would require that Europe shed its penchant for ambiguity. Hard specifics are essential.
To begin with, myriad details on legal provisions for halting debt service payments, placing stays on creditor litigation and establishing a forum for negotiating restructuring terms must be sorted out. But even more important are questions about some bigger picture issues critical to a credible threat of restructuring.
Will there be access limits on use of ESM funding (the IMF’s experience suggests that without them, the pressure for bail-outs is rarely resisted)? What happens when there are disagreements among European countries on the “solvency” assessment (the text suggests that every country has veto power)? What happens when the IMF and European institutions differ on thisassessment? How would private creditors be “encouraged” to maintain their exposure to “solvent” countries experiencing liquidity problems? How, in instances when the debt of a restructuring sovereign is a non-trivial share of financial assets in a creditor country (especially when their banking systems are fragile), will the knock-on effects of restructuring be handled? This last problem seems to be a determining factor (along with the risk of contagion to Spain and Portugal) in the decision to bail-out rather than restructure in Greece and Ireland.
Does the will to agree on such contentious issues exist? After all, the notion of getting tough on private creditors in resolving financial crises is an old one. But proposals for mechanisms to facilitate restructuring—most recently the Sovereign Debt Restructuring Mechanism(SDRM) by the IMF—have been successfully resisted by financial sector lobbies (out of obvious self-interest) and, ultimately, by governments (under the influence of lobbies as well as fear of the unknown).
The ambiguity in the ERM announcement reflects enormous frictions around Europe’s approach to debt crises. It is not clear these frictions can be overcome without(or prior to) a worsening of the current debt crisis. But while ambiguity persists, it contributes to the very contagion Europe fears. A well-crafted restructuring mechanism, rather than worsening contagion, would likely help settle markets.
Susan Schadler is a non-resident Senior Fellow with the Atlantic Council and formerly Deputy Director of the IMF’s European Department. Photo Credit: AP Photo