The global financial crisis has spread from private companies and individuals and now threatens the finances of sovereign governments, particularly in Europe. The argument over what to do rages, with recent contributions to this site including Black (2010) and Nickel et al. (2010).
Within this debate, proponents of a European Sovereign Debt Restructuring Mechanism are currently facing of a backlash. Calls for a European-wide mechanism are viewed as the principle cause for the escalation of the crisis in Ireland and contagion within the Eurozone. At the same time, critics such as Nouriel Roubini (2010) have pointed out that an essential function of a Soveriegn Debt Restructuring Mechanism (SDRM) – creditor coordination in a debt restructuring – can be achieved in less heavy-handed way using debt exchange offers, as demonstrated in a dozen or so cases in the late 1990s and the early years of this decade. Viewed in this light, the debate on a European SDRM seems useless at best – and dangerous at worst.
However, the European SDRM critics – and even more regrettably, some of its proponents – miss a basic point. The case for an SDRM in Europe does not primarily rest on its supposed ability to resolve debt crises smoothly and in a bailout-free way. Rather, its promise lies in preventing future crises in a Eurozone in which formal mechanisms for disciplining fiscal policies have proved insufficient. A credible SDRM defines an endpoint which anchors expectations and aligns incentives. Increasing spreads on sovereign bonds act as powerful incentives for profligate countries to undertake adjustment and for all countries to reassure investors that they are not in the profligate category. Thus, a well-designed SDRM for Europe could serve to mobilise market discipline in support of policy discipline.
The tricky problem is that this debate is not taking place behind a veil of ignorance but rather in an ongoing financial crisis, where market participants are nervously eying possible changes in the rules of the game. The only way to deal with this problem is to clearly separate the two regimes. There should be no doubt that a European SDRM would not be used to resolve ongoing debt crises but only future ones – it would only concern debt issued under a new regime.
But there can also be no doubt that the debate on the European SDRM’s design needs to happen now, while fiscal problems are fresh and there is will to reform. Getting the design right requires reflecting two basic lessons from past debt crises in emerging and advanced countries1 (Sturzenegger and Zettelmeyer 2007a and 2007b).
Painful restructuring and painful politics
A first lesson is that debt restructuring is always painful. Even defaults that achieve creditor coordination and in which governments negotiate in good faith (that is, in line with their debt service capacity) have output costs because of the links between the sovereign balance sheet and the domestic financial sector, and because of the austerity imposed by the loss of market access while negotiations are ongoing. Orderly debt restructuring can shorten the pain, but is no “easy way out” for governments.
The second lesson in part follows from the first: the politics of fiscal crises tends to bias policymakers both against timely adjustment and against debt restructuring. Serious fiscal adjustment is often delayed until debt restructuring is likely, and debt restructuring is delayed until it happens under duress. Defaults are typically preceded by “gambles for redemption” involving exceptional fiscal adjustment in conjunction with crisis lending (famous examples include Russia in 1998 and Argentina in 2001). To be sure, these gambles sometimes succeed (as in the case of Brazil in 2002 or Turkey in 2001), and when they do, this is a better outcome than default (although not better than timely fiscal adjustment). But generally, the bias of policymakers is to postpone action – whether it is adjustment or default – beyond the point in which action would make sense in the national interest.
These observations have three main implications for the current debate on Eurozone economic governance.
First, a debt restructuring mechanism should not be the first line of defence for countries that come under pressure in the bond markets. Denying countries official support that could solve their problems through a combination of fiscal adjustment and external financing creates spurious suffering and makes them an easy target of speculation. For this reason, the Eurozone requires a permanent crisis fund.
Second, this crisis fund should be supplemented by a European Sovereign Debt Restructuring Mechanism for highly-indebted countries. This would consist in a legal framework, activated by the debtor country, that allows an orderly debt restructuring negotiation and makes its outcome binding on all creditors2. The rationale for such a framework is not that it would offer an easy alternative to crisis lending (although it is certainly preferable to a chaotic default and at least as good as a well-run debt exchange). Rather, a credible SDRM (note the caveat) would be useful as a source of fiscal discipline.
Third, access to European crisis lending must be tied to use of the ESDRM for countries whose fiscal track record falls short of minimum standards. If this is not the case, the ESDRM will lack credibility, because countries that can draw on European crisis lending are very unlikely to invoke the ESRDM even if their debts are unsustainable. By the same token, an SDRM for Europe is unlikely to be invoked if access to the crisis fund is controlled by Eurozone countries collectively, as they may fear contagion from the country that is forced to undergo a debt restructuring. After the crisis has arrived, it will usually seem attractive to gamble for redemption--even collectively.
Why should debt restructurings be handled in the context of a formal ESDRM rather than simply requiring an ad hoc restructuring (say, via a debt exchange)? There are two main arguments. First, it is important that the restructuring process be well synchronised with the adjustment programme associated with access to European crisis lending. In particular, under the ESDRM the European Commission could be given powers to approve an agreement negotiated by creditors and the debtor before it becomes binding on all creditors. This would ensure that the debt restructuring is sufficient to restore debt sustainability, but also that it reflects the country’s medium term capacity to pay. Second, creating a formal debt restructuring mechanism in Europe that all Eurozone countries have agreed to will add legitimacy to the requirement that some countries invoke the mechanism under certain conditions if they wish to access European crisis lending. This will help offset political biases that work against undertaking a debt restructuring. Simply asking countries to restructure without giving them help and guidance in the form of a process that they themselves have endorsed ex ante does not have the same effect.
A European crisis resolution mechanism that meets the three conditions could look roughly as follows. Based on observable triggers, two thresholds of fiscal soundness would be defined. The Maastricht fiscal criteria – debt below 60%, deficits below 3% – could constitute the “lower” threshold. Countries that meet these conditions could draw on EU crisis funds any time without conditionality. The “upper” threshold would need to be a simple criterion– tamper-proof, and removed from political discretion--designed to identify countries that have failed to meet a common standard of responsible fiscal behaviour. Countries that do not meet the Maastricht criteria but meet the upper threshold could have access to EU funds with standard fiscal conditionality. Finally, countries above the upper threshold would only access European official support, if they agreed to invoke the ESDRM at the same time.
How could such the upper threshold be defined? Compared with other regions of the world the Eurozone is in a unique position because it already has a shared fiscal framework, which can be used as a point of reference (see for example German Council of Economic Experts 2010). In the framework of the Eurozone, one could envisage simple quantitative indicators of indebtedness, an automatic link with EU surveillance framework, or a combination of both:
- A quantitative automatic trigger (for instance, based on a specific debt to GDP ratio) has the advantage of simplicity and transparency. The disadvantage is that it is bound to be an imperfect proxy for the actual debt servicing capacity of any country since this depends on financial, macroeconomic as well as political constraints. If the indebtedness threshold is set too low, countries that could recover through fiscal adjustment will be cut off from crisis lending, but if it is too high, this means that the mechanism loses its effectiveness as a disciplining device (See German Council of Economic Experts 2010). In practice, that means that the threshold should be set well above the current 60% limit, but below the debt levels of the highest indebted Eurozone countries today. These countries would need to be exempt from the access restriction during a transition period over which they gradually reduce their debt ratios.
- Alternatively, access to European crisis lending could be tied to the Eurozone process for monitoring fiscal discipline and implementing early corrective action, which is being strengthened now, through an automatic link to the Stability and Growth Pact. In particular, the trigger could be linked to a previous Commission recommendation of a sanction under the excessive deficit procedure.
The mechanism that we propose will not solve all of Europe’s economic governance problems. Nor will it help with private sector indebtedness, for example, and it does not prevent fiscal problems that are induced by banking sector problems, as is the case in Ireland. These issues must be addressed in other ways, including through EU level supervisory institutions, and the new European Systemic Risk Board. What our proposed SDRM-backed crisis resolution mechanism could help with is perhaps the Eurozone’s least tractable problem, namely, aligning fiscal policies of around a common responsibility standard. As such, it is likely to be an integral part in a European financial architecture that is currently being rebuilt to prevent crisis, as well as to manage them.
Black, Stanley W (2010), “Fixing the flaws in the Eurozone”, VoxEU.org, 23 November.
German Council of Economics Experts (2010), Jahresgutachten 2010/11, Wiesbaden.
Gianviti, François, Jürgen von Hagen, Anne O. Krueger, Jean Pisani-Ferry, and André Sapir (2010), A European mechanism for sovereign debt crisis resolution: a proposal, Bruegel Blueprint, November.
Hagan, Sean (2005), “Designing a Legal Framework to Restructure Sovereign Debt.” Georgetown Journal of International Law, 36(2): 299–403.
IMF (2002), “The Design of the Sovereign Debt Restructuring Mechanism—Further Considerations”, Washington: International Monetary Fund.
IMF (2003), “Proposed Features of a Sovereign Debt Restructuring Mechanism”, Washington: International Monetary Fund.
Krueger, Anne O. (2002), A New Approach to Sovereign Debt Restructuring, Washington: International Monetary Fund.
Nickel, Christiane, Philipp Rother, Lilli Zimmermann (2010), “Major public debt reductions: Lessons from the past, lessons for the future”, VoxEU.org, 21 November.
Panizza, Ugo, Federico Sturzenegger, and Jeromin Zettelmeyer (2009), “The Economics and Law of Sovereign Debt and Default,” Journal of Economic Literature, vol. 47(3), pages 651-98, September.
Roubini, Nouriel (2010), “Irish woes should speed Europe’s default plan”, Financial Times, 15. November.
Sturzenegger, Federico and Jeromin Zettelmeyer (2006), Debt Defaults and Lessons from a Decade of Crisis, Cambridge, Mass: MIT Press.
1 See, for example, Sturzenegger and Zettelmeyer (2006), and Panizza, Sturzenegger and Zettelmeyer (2009).
2 See IMF (2002, 2003), Krueger (2002) and Hagan (2005). For a recent application to Europe, see Gianviti et al (2010).