1 Introduction
The potential role of debt restructuring mechanisms in the constitutional set-up of the European Monetary Union (EMU) has received considerable attention from academics. Following earlier reflections on developing countries and the IMF (Krueger
2002), the euro-area debt crisis kicked-off a large and still growing literature on how to organize debt restructuring for the euro area in an orderly way (Bénassy-Quéré et al.
2018; Fuest et al.
2016; Gianviti et al.
2010; Gros and Mayer
2010; Mody
2013).
Academia’s keen interest in sovereign debt restructuring mechanisms (SDRM) for the euro area stands in sharp contrast to the topic’s neglect among EU institutions. The European Commission’s
2017 “Reflection Paper on the Deepening of the Economic and Monetary Union” is an illustrative example (European Commission
2017). The paper is highly ambitious with respect to the completion of the banking union (European Deposit Insurance Scheme), new debt instruments (sovereign bond-backed securities), a new macroeconomic stabilization function (e.g. a European unemployment insurance scheme), the establishment of a European Monetary Fund (EMF) or the establishment of a euro area Treasury. At the same time, it does not include any hint to the possible role and organization of an SDRM. The Commission’s disregard of issues related to debt restructuring continued in the “Saint Nicolaus’ package”, the comprehensive set of detailed EMU reform plans presented by the European Commission in December 2017. Once again, it offered no solutions on how to cope with an insolvent euro area government. Even the massive fiscal solvency shock as a result of the Covid-19 pandemic has so far not triggered a new European SDRM debate.
One obvious explanation for this reticence of European political institutions is the fear that the mere existence of an SDRM could destabilize government bond markets. But this does not suffice to explain why European institutions hardly discuss the issue. Recent academic studies on a European SDRM are fully aware of its challenges and have offered various strategies for coping with the problems (Bénassy-Quéré et al.
2018; Fuest et al.
2016).
This article provides political economic explanations for the divergent positions taken by various parties on explicit sovereign debt restructuring in a future EMU. It covers the following key players: the European Commission, the European Parliament, the European Central Bank (ECB) and the governments of high-debt and low-debt euro area countries.
The political economy of an SDRM has received substantial academic attention in the context of the IMF model for developing and emerging countries proposed in 2002 (Krueger
2002). The IMF model wanted to address the procrastination problems with over-indebted economies. Too often, countries with unsustainable debt levels delayed restructuring to the detriment of both creditors and the domestic economy. Proponents of an SDRM wanted to promote a predictable, orderly and rapid restructuring that could overcome the coordination failures of ad hoc debt negotiations. After an intense debate, the Krueger SDRM model failed to gain sufficient political support from key players (Quarles
2010; Roubini and Setser
2004; Setser
2010). Borrowing developing countries were afraid to lose sovereignty as the IMF would have gained jurisdiction over domestic-law debt and exerted an even stronger impact on domestic policies. Creditor countries were concerned about the moral hazard effects of possibly too quick and generous restructurings and, not unlike borrowers, the growing IMF power. Moreover, the US administration under President George Bush favored contractual market-based solutions instead of a statutory restructuring mechanism and, therefore, pushed the use of Collective Action Clauses (CACs) in bond contracts. The shifting attention towards CACs brought the IMF-centered SDRM debate to an end (Gelpern and Gulati
2013).
CACs can alleviate restructuring negotiations as they define creditor voting rules and qualified majorities of bondholders that bind all bondholders within the same issuance to the restructuring terms. However, CACs are not at all a full substitute for a fully developed SDRM since such a mechanism goes far beyond the definition of voting rules for bondholders (Krueger and Hagan
2005; Roubini and Setser
2004): An SDRM establishes a comprehensive framework to prepare, negotiate and execute a sovereign debt restructuring. It sets up institutions and committees for the restructuring negotiations; it covers a wider range of sovereign debt instruments beyond bonds; like in private insolvency procedures, an SDRM defines debtor information requirements and debtor protection with equal-treatment of diverse creditors; it provides temporary liquidity to the creditor over the period in which the restructuring procedure is ongoing; and it sets incentives for prudent and responsible policies in the transition phase.
This older IMF debate is a starting point for this analysis, which considers the support for a European SDRM in the institutional context of the euro area. Like for the IMF SDRM, the debtor-creditor antagonism plays a key role in in the current European setting. However, other issues of the earlier debate are of less relevance in Europe today. With strong supranational EU institutions, the shift of power from the nation states to a higher level is already far advanced in Europe. Hence, one of the key counter-arguments against the IMF SDRM—a loss of national sovereignty—is much less convincing in the current European debate.
This study finds that the diverging positions are consistent with institutional self-interests. For the European Commission and the European Parliament, the absence of debt restructuring increases the need for large and permanent centralized fiscal instruments in line with the centralization interests of these institutions. The ECB position is ambivalent. From a monetary policy perspective, the ECB has a strong interest in a smooth debt restructuring whose burden falls on private investors in order to avoid any monetary involvement in a bail-out. But the ECB today is massively exposed to euro area sovereign debt and might, therefore, fear write-offs that are likely to violate the legal ban on monetary financing. Moreover, the ECB likely fears the fall-out of restructuring for banking stability given its banking supervision mandate.
For euro area governments, the case is asymmetric, but there is room for compromise. Low-debt countries fear the burden of transfers if high-debt countries become insolvent and no credible restructuring mechanism exists. Conversely, high-debt countries with a non-negligible risk of future insolvency prefer transfers over a debt cut, with all its economic and political costs. The analysis concludes that a non-transparent transfer arrangement like the one applied in Greece could be an acceptable compromise for everyone. Hidden transfers need substantive and permanent fiscal instruments, which are in the centralizing interests of the Commission, the Parliament and the European bureaucracies. Hidden transfers avoid visible problems for the ECB balance sheet and are not at odds with its banking supervision mandate. Moreover, hidden transfers are in the interests of high-debt countries because they effectively reduce the debt-service burden. Finally, non-transparency helps limit the political costs for incumbent governments in sustainable debt countries who have to bear the burden of the effective bailout.
The next section explains the role of transfers and debt restructuring in a European fiscal union with regard to two inconsistent taboos in the current reform debate. Section
3 looks in detail at the interests of important institutions. The empirical section introduces the EMU Positions Database and tests several predictions. The final section examines the implications for a possible compromise and discusses recent fiscal innovations in the corona pandemic in the light of the paper’s findings and predictions.
2 Two inconsistent taboos
Talk of sovereign debt restructuring is not the only taboo in the euro reform debate. None of the important official EMU reform templates includes any explicit transfer element. Any new fiscal capacities (e.g. European unemployment insurance) or loan instruments (European Monetary Fund) are presented as part of an
insurance narrative. The defining element of any insurance scheme is that there is no systematic ex ante redistribution (from rich to poor or from low-debt to high-debt countries). But an institutional arrangement that excludes transfers and sovereign debt restructuring simultaneously is inconsistent (Rodden
2017). A consistent design can either exclude sovereign debt restructuring or exclude a transfer solution. But it cannot coherently exclude both elements at the same time if there are (or could be in the future) cases of sovereign insolvencies. Conceptually, a country is insolvent if the present value of future revenues does not suffice to balance the current debt stock and the net present value of future expenditures, even for the maximum feasible fiscal adjustment (Das et al.
2012).
Three basic solutions are available for an insolvent country:
-
Unexpected positive solvency shocks Examples are structural reforms that are surprisingly courageous and successful in boosting an economy’s growth potential, technological innovations, the discovery of natural resources, and improvement in terms of trade. Positive shocks of any such type could turn a situation of insolvency into solvency.
-
Debt restructuring (at the expense of private creditors) A debt restructuring that reduces the net present value (NPV) of debt service obligations can restore debt sustainability. NPV effects can be achieved through multiple instruments (Das et al.
2012): haircuts that reduce the face value of a debt obligation; a maturity extension that postpones the repayment obligation; and interest rate reductions. All these instruments involve redistribution from the lender to the borrower.
-
Transfers (at the expense of other jurisdictions’ taxpayers) In the absence of a positive solvency shock, the only alternative to private creditor debt restructuring are transfers from other sovereigns (Zettelmeyer et al.
2013). The insolvent country can be rescued through transfers from countries, international institutions and central banks. Transfers can have various forms and be explicit or implicit and, hence, have very different levels of salience. A cash bail-out from other countries would be a particularly salient and direct way to reduce the debt service NPV. An identical effect can be achieved through preferential loan assistance. Financial assistance includes a transfer element whenever interest rates do not include a risk spread that fully reflects the debtor’s credit risk. The transfer element in any such financial assistance amounts to the face value of the financial assistance minus the NPV of the debtor country’s repayment obligation calculated on the basis of a risk-adequate discount rate.
One important caveat relates to the difficult distinction between illiquidity and insolvency. The euro area debt crisis with it panic-driven contagion in the 2010–2012 period has demonstrated that countries can fall victim to liquidity crises that would be otherwise manageable in calm market environments. De Grauwe and Ji (
2013a) point out that a liquidity crisis can turn into a solvency crisis if, for example, illiquidity forces a country to pursue austerity measures that damage a country’s long-run growth. According to the multiple equilibria theory, a self-fulfilling prophecy may emerge in which a country becomes insolvent because investors fear insolvency (De Grauwe and Ji
2012). In such a case, preferential financial assistance may prevent insolvency in the first place.
De Grauwe and Ji clarify that past or future euro area insolvencies are not necessarily the result of a self-fulfilling prophecy. In their multiple equilibria model, they show that the distinction between illiquidity and insolvency is blurry only for an intermediate range of fundamental indicators. If the fundamentals deteriorate below a critical level, even optimistic market sentiment cannot restore solvency (De Grauwe and Ji
2013b). For these cases the only remaining decision is whether to pursue private debt restructuring or transfers (of whatever type).
So far, there has been one instance in the euro area where debt sustainability was fundamentally lacking without reasonable doubt: namely, Greece in 2010–2011 (Zettelmeyer et al.
2013). The experience with Greece confirms that any such situation must trigger a debt restructuring or a transfer solution. Interestingly, Greece underwent both debt restructuring and transfers. In 2012 the Greek “private sector involvement” (PSI) restructured private Greek debt with a face value totaling more than 100 per cent of Greek GDP. Depending on discount assumptions, the NPV loss imposed on private creditors was 50 per cent or higher (Zettelmeyer et al.
2013). However, the PSI was insufficient to restore solvency so that substantial implicit transfers were required as well. These were given by means of preferential financial assistance from EU member countries (direct bilateral loans), ECB bond purchases through the Securities Market Program (SMP), the European Financial Stability Facility (EFSF), and the permanent European Stability Mechanism (ESM) (Buchheit and Gulati
2018).
Given the current state of public finances in the EMU, more cases of fundamentally insolvent euro countries are likely in the future. In its 2020 Debt Sustainability Monitor published before the outbreak of the Covid-19 pandemic, the European Commission identifies persistent fiscal sustainability risks and identifies seven EU countries “at high fiscal sustainability risk in the medium-term” including five euro area members (Belgium, Spain, France, Italy, and Portugal: European Commission
2020a). This debt sustainability analysis explicitly took account of the downward trend in government interest rates, which supports debt sustainability. Undoubtedly, with the pandemic and its massive fiscal and economic fallout, risks for future insolvencies in the euro area have further increased since high-debt countries such as Greece, Italy, Spain and France have experienced a particularly severe and probably lasting economic damage from the pandemic (European Commission
2020b).
If it is to develop a realistic overall strategy, Europe must prepare for new sovereign insolvencies beyond Greece. Rejecting the SDRM for euro area countries with the argument that insolvencies will not occur in the future is wholly unconvincing. Given Europe’s currently further deteriorating fiscal conditions, it must either open the way for debt restructuring or accept (implicit) transfers for future cases of insolvency.
In the next sections, I consider the interests of crucial players with regard to SDRs and transfers.
5 Hidden transfers as political-economic equilibrium
Both the anecdotal and the empirical evidence confirm the expected conflict of interest between low-debt EMU countries (in favor of SDRM and opposed to transfers) on the one hand and high-debt countries, the Commission, the Parliament and the ECB (opposed to SDRM and in favor of transfers) on the other. The question is which compromise is feasible. As noted in 3.5, fiscally sound countries are more willing to consider transfers if they are non-transparent and escape voter notice in the donor countries. The model case for hidden transfers to an insolvent country is Greece, where the ESM has lengthened loan maturities and decreased interest rates. Maturity profiles are now back-loaded into the very distant future (with maximum maturities extending into the 2060s). Hidden transfers can be quantified by comparing the nominal loan with the present value of agreed interest and maturity payments using a risk-adequate discount rate. In Greece, simple model calculations point to effective transfers amounting to more than 50% of nominal loans (Buchheit and Gulati
2018).
Hidden transfers satisfy all political and economic constraints. In the case of Greece, the government and citizenry have benefitted from a sharply reduced debt service for a politically relevant time horizon. The Greek settlement sent a signal to sovereign bond markets that EMU member countries can rely on long-run financial assistance. The signal has alleviated market pressure on other high-debt euro countries whose debt sustainability is disputed. The European Commission and the Parliament have also benefitted from a new and lasting European fiscal institution (ESM), which they hope to control to some degree by passing into EU law. Moreover, the ECB is satisfied because Greece no longer endangers the stability of European banks or constrains monetary policy decisions. Finally, given the absence of an immediate budgetary impact and the scant attention it has received by the media and the general public, the ESM has reduced the level of voter anger in low-debt countries such as Germany, Netherland, and Finland. Overall, the Greek solution offers a model case for future sovereign insolvencies in the EMU.
6 Conclusions
Realistically, additional cases of insolvent EMU countries cannot be excluded for the coming years in view of the poor state of public finances in numerous euro countries already before the pandemic, the unwillingness to create fiscal buffers during times of prosperity (European Fiscal Board
2020), and the massive new solvency shock that has occurred since 2020 (European Commission
2020b). If the EU rules out an SDRM, transfers are the only remaining alternative for these cases. If open transfers fail to receive political support in donor countries, hidden transfers will be the compromise that satisfies all the political and economic constraints.
Various features of the new pandemic-induced European monetary and fiscal instruments actually point into the direction of hidden transfers. With the new asset purchases under PEPP, the ECB has abandoned several earlier precautions against excessive exposure to high-debt euro countries (Havlik and Heinemann
2020b). The ECB Council has lowered the credit quality standards for eligible securities and now accepts Greek sovereign bonds that previously, due to the country’s unfavorable credit rating, were excluded. It has furthermore given up a strict allocation of purchases across countries according to the country shares in the ECB capital key and effectively overweights high-debt countries. Moreover, the ECB had to accept that the Eurosystem’s holdings of euro area government bonds surpass the blocking minority thresholds defined in the CACs. This implies that the ECB Council will have a veto power in future bondholder votes, which makes a CAC-based debt restructuring highly unlikely.
Also the financing of the EU corona recovery plan can be interpreted as a move towards a transfer solution. From the 750 billion euro package, 390 billion euros are paid out as non-refundable grants and 360 billion euros as loans. This 750 billion euro package is fully debt-financed through the issuance of EU bonds guaranteed by the EU budget. However, the EU capacity to repay the debt is ultimately secured through increased EU claims to Member State contributions (Heinemann
2020). The duration of this financial operation is very long with the repayment of maturing bonds dragging on until the year 2058. According to the binding international treaty on the EU own resource system, a long-lasting joint liability for the corona debt was agreed (Council of the European Union
2020): Whenever in the coming four decades one Member State defaults on its European financial obligation or it leaves the EU without a financial deal, its share will be distributed across the remaining solvent EU countries. Hence, the refinancing scheme for the corona debt previews additional transfers from other countries as a solution whenever a country is unable to pay. All these liability and transfer implications have almost fully escaped the public perception due to the complexity of the institutional design. It might be too early to finally judge, whether these decisions only reflect the exceptional circumstances of the pandemic or whether they signal a permanent course. However, decisions taken in the pandemic crisis are precedents for new crises. These precedents are fully in line with the expectation that hidden transfers are the most plausible European answer to future insolvencies of euro area Member States.
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