Debt in Europe is very high. The chief debtors at the government level aside from Greece are Italy and Portugal, but France, Spain, and Belgium too have government debt close to or beyond 100% of GDP.
European debates rage about risk reduction v. risk sharing. Additionally, history is littered with sovereign debt restructurings; and history repeats itself.
Questions over private sector involvement in bearing the cost of high or unsustainable debt are inevitable. For Europe, this is an area of extraordinary sensitivity. Every step carries risks of political setbacks and market upsets, particularly in view of tensions displayed at the Brussels summit on 29 June over sharing the burdens of migration.
German Chancellor Angela Merkel and French President Emmanuel Macron added to this debate by introducing into their pre-summit ‘Meseberg declaration’ (named after their meeting in a Baroque palace near Berlin) this recondite sentence: ‘To improve the existing framework promoting debt sustainability and to improve their effectiveness, we should start working on the possible introduction of euro-CACs (collective action clauses) with single-limb aggregation.’
Behind this bewildering phrase lurks a spectre haunting Europe: a spirited controversy between countries with low and high debt about what to do in the event private sector lenders head for the exit and subject indebted governments, needing European Stability Mechanism support, to an escalating spiral of distress and default.
CACs are written into sovereign bond contracts to allow a bond to be restructured under certain conditions, including that a large majority of the bondholders agrees to write-downs. This reflects the reality that, unlike in a national bankruptcy, international creditors cannot be constrained to bear losses in court; a global sovereign bankruptcy court does not exist, and probably never will, in view of national sovereignty.
The Meseberg CAC reference mirrors long-standing euro area reform battles. Germany and the Netherlands wish to impose ‘automatic’ write-downs on private sector holders of government debt for any country seeking support from the ESM, due to become the European Monetary Fund. France and Italy, however, fearing that would lead to higher spreads and market instability, say such action crosses a ‘red line’.
In principle, the Germans and Dutch are right – investors take risks to earn rewards and they should bear the consequences of their actions, rather than taxpayers. Market discipline is salubrious. Moral hazard is to be avoided. Unfortunately, the real world is not so simple. Imposing write-downs automatically on private holders in return for ESM support is a bad idea, for four reasons.
First, if a state faces illiquidity rather than insolvency, providing financial support and avoiding a restructuring is far less harmful to the country. But determining whether a country is illiquid or insolvent is not straightforward. Judgements about debt sustainability are subjective and many cases offer up shades of grey. One must assess the country’s debt burdens and deficits, its potential growth rate, and its capacity to adjust and run primary surpluses. Responsible policy-makers should not push countries into insolvency.
Second, write-downs are often needed to eliminate a debt overhang. But they can be highly costly. Countries can lose access to credit markets for long periods. Large national balance sheet losses can emerge and decapitalise banks when they hold significant amounts of national sovereign bonds.
Third, automaticity can set off self-fulfilling market runs and contagion. Market participants, fearing an automatic restructuring in a country, would have every incentive to be the first mover and dump paper. Short-term positioning would be rewarded, buy-and-hold investors penalised. Market selling might then move to the next vulnerable country.
Fourth, the external climate matters. A restructuring of private sector holdings of Greek debt in May 2010 could have engendered massive contagion in global markets. By 2012, markets were able to accommodate it.
In 2010, Merkel and then French President Nicolas Sarkozy took a stroll on the beach in the French seaside town of Deauville. They decided losses could be imposed on private creditors of indebted European states, as a condition for the country receiving support from the European bail-out mechanism. Greek, Irish and Portuguese bond spreads immediately soared. Ireland and Portugal lost market access. European taxpayers did not save money. Future solutions over CACs must learn the lessons of Deauville.
Mark Sobel is a former Deputy Assistant Secretary for International Monetary and Financial Policy at the US Treasury. Until earlier this year he was US representative at the International Monetary Fund. He chaired the international public-private group that developed the single-limb clauses in 2014.