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Biting the insolvency bullet

How facing the facts about chronically indebted member-countries can bring stability to the eurozone.

By Lucrezia Reichlin and Hélène Rey 31 May 2016

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Europe’s fiscal jigsaw is missing a key piece, a regime for dealing with insolvent countries. In the absence of a proper sovereign debt restructuring mechanism, creditors cling obstinately to the fiction that their continuing lending to such countries will one day be repaid. An insolvency regime is urgently required and, we believe, could be swiftly implemented without the need for fresh treaties or new European institutions.

The European Union, despite many achievements, has so far failed to establish institutions sufficiently robust to withstand the crises the refugee crisis or to deal with excessive sovereign debt in the single-currency area. Given the rise in political extremism and populism in many countries, it is not impossible that the Europe we have known for half a century may be coming to an end.

Addressing the issue head on


Therefore, this is a time for urgent measures that can be implemented quickly and do not rely on lengthy negotiations over grand designs for “more Europe”, desirable though some of those designs may prove.

We suggest a consistent set of measures, based on the belief that a sovereign debt restructuring regime (SDRR) is one of the missing piece of the Eurozone’s fiscal architecture. Such a regime would address head on the issue of insolvency among distressed members of the Eurozone, in place of the current refusal to face up to it.

We also suggest a new stability fund, which would buy and then retire the excess debt of insolvent members of the single-currency bloc. A third essential feature, we believe, would be the creation of a safe asset constructed from a basket of Euro area sovereign debt, ending the current bias in bank holdings in favour of home-government bonds that has proved such a force for instability.

The central principle of crisis action by official lenders is never to lend into insolvency, a principle upheld by, among others, the International Monetary Fund (IMF). But because the Eurozone has no SDRR, lenders have tended to ignore serious solvency concerns, put off the day of reckoning and provided additional lending – the infamous process known variously as “extend and pretend” or “kicking the can down the road”.

This point is especially important in light of the need for the European Stability Mechanism (ESM) to function successfully. This permanent agency, capitalised at €500 billion, should not lend into insolvency. On the contrary, the SDRR ought to emerge as a complement to the ESM, taking care of insolvent member-states while the ESM lends only to those that are “conditionally solvent”, meaning that they will be able to pay off their debts on condition that they implement fiscal adjustment and structural reforms.

We propose that the criteria for judging whether or not a country is at risk of insolvency should be clear and consistent. Should total public debt reach or exceed 90 per cent of gross domestic product or should the country’s gross financing needs exceed 20 per cent of GDP and the country loose market access then debt restructuring should take place.

For those mindful of recent problems with regard to Argentina and elsewhere, there would need to be some way of preventing so-called hold-out creditors – minority debt-holders determined to force a better deal from the debtor-government – from delaying the entire process. 

Dealing with legacy debt


One solution may be to write a clause into the ESM’s founding treaty granting immunity from legal action to governments that have reached agreement with a large majority of creditors.

But before one could think of establishing the SDRR, one needs to deal with the legacy debt – the debt inherited from the global financial crisis- and bring down the debt to GDP rations below 90%. The stability fund would be established to do just that. It would be backed by the sovereign governments of the Eurozone and buy back the debt of euro area countries in a short time period. It would issue bonds to finance its purchases, and these bonds would be secured on future tax revenues due to those governments, including possibly seignirorage, VAT, wealth taxes, carbon levies and so forth. The fund would then retire the debt it bought. This debt buy back would be a one-off operation and would only take place under the agreement that all countries sign up to the new SDRR in order to avoid moral hazard.

How big a bazooka – to use the phrase attached in recent years to the European Central Bank’s operations in the sovereign debt market – will the fund prove to be? Our calculations look at various possibilities. For example, under the assumption that each country commits 0.5 per cent of GDP to the fund every year for a 50-year period. The net present value of such a commitment would be €2 trillion, with a further €1 trillion available if the governments contribute part of their seigniorage revenues– the profit the ECB makes from issuing currency, which is then rebated to the countries.

Breaking home-state bias


In parallel with such a dramatic move to reduce excessive debt and get to grips with sovereign insolvency should be action to break the link between banks and sovereign governments, created by the home-state bias of banks when buying bonds. This bias, which actually becomes more pronounced during times of financial stress, makes a major contribution to Eurozone instability because it ensures that the problems of the sovereign nations concerned become the problems of that country’s banks – and vice versa. 

There are many possible reasons for this bias. It could be that governments make it clear that they expect “their” banks to invest in domestic bonds, or perhaps the banks buy the bonds in the hope of special treatment in the case of a sovereign default. Maybe the banks realise that their own fate and that of their home government are deeply intertwined, in which case, of course, bond buying will have the unwelcome effect of further tightening that link.

One way to break what can be called the bank-sovereign loop would be to set a limit of the sovereign exposure allowed for each bank. But this would have two highly undesirable side effects. First, there would be market turbulence as banks re-weighted their portfolios to comply with the new rules. Second, there would be every incentive for the banks to invest in riskier, higher-yielding sovereign debt, to make the most of their new, restricted “allowance” of such investments.

A better way, we believe, would be for the ECB and ESM to calculate risk weights for each country’s sovereign debt and then to invite private-sector entities to create collateralised debt obligations (CDOs), made up of packages of different sovereign bonds, which banks would be encouraged through regulatory incentives, to buy in preference to simply investing in their home-state bonds. 

The size of the ECB and the euro-system central banks means that the portfolio rebalancing could be carried out without generating large-scale market turbulence. These institutions would be able to act as the channel through which national sovereign debt was swapped for then new, diversified bonds. 

Creating a Eurozone safe asset


The creation of these bonds would bring into existence what has so far proved elusive: a Eurozone safe asset. It would also have usages beyond the banking system, providing an alternative asset in the insurance and pensions-fund industries, which have traditionally shared the banks’ bias towards home-state bonds.

Taken together, the stability fund, the SDRR and the proposal for a Eurozone safe asset meet, we believe, the need for urgent action that can be undertaken without lengthy discussions of treaty changes or of the creation of new, over-arching institutional structures. The “Five Presidents” report of 2015, by contrast, may be seen as admirable in its ambition for deeper political and economic union, but its implementation would take time even assuming there is sufficient appetite at the present time for any such development.

Our proposals, we believe, would have the added advantage of leading to a better balance between fiscal and monetary policy in the Eurozone, since it would relieve the ECB of the excessive responsibility it has now with regards to macro-economic stabilisation and would trigger an immediate upsurge in spending capacity as people, companies and governments in troubled member-states were freed from the burden of present and future repayments on excessive debt.

But a word of warning. Our proposals ought to be seen as a package, each part of which supports the other. It would be a grave mistake were a lack of political will to cause governments to seek to cherry-pick those ideas that they like while ignoring those that they do not, or that they fear may prove electorally unpalatable.

Implementing our proposals would involve disregarding none of the principles of economic and monetary union agreed 25 years ago. They would not create a “debt union” or a joint debt guarantee. They work with and not against market discipline.

And they require no new European institutions or European treaties. Time is short. The moment to act is now.

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