Notwithstanding the 21 July 2011 policy package announced by Eurozone heads of state and governments, the EU remains stuck in the worst fiscal crisis of its history.1 The 21 July announcement constituted the most comprehensive attempt so far to arrest the crisis. Proposals included:
- Adapting financial conditions of EU/IMF-supported programmes in Greece, Portugal, and Ireland;
- calling for private sector involvement in the Greek programme for the first time; and
- extending the powers of the European Financial Stabilisation Facility (EFSF).
It nonetheless failed. There were two reasons for this:
- It did going far enough in the main areas that it sought to address;
- it failed to offer a new perspective on reform of Eurozone economic governance which would have anchored medium-term market expectations and generated political support for exceptional short-term efforts, reassuring the public that these efforts will remain exceptional.
Avoiding the “bridge to nowhere” outcome
To be more successful, the next policy package must get ahead of these expectations. Three things will be necessary.
- First, it must present a comprehensive immediate plan that both addresses the solvency problems of Greece and the contagion problem.
- Second, it must offer a vision – and indeed timetable – for institutional reform that addresses the root causes of the crisis.
- Third, it must ensure that both sets of initiatives are consistent and that the transition to stronger governance regimes is managed in a way that minimises short-run counterproductive effects.
Without these last two elements, even a very large short-run stabilisation package could be perceived as a “bridge to nowhere” that is not anchored in a sustainable future regime.
A plan that addresses all three issues
Short-term stabilisation in Europe must have three aims:
- Ensuring solvency of European sovereigns.
This requires a deep restructuring of Greek sovereign debt. Other sovereigns can re-establish or maintain solvency through a combination of fiscal adjustment and pro-growth structural reforms.
- Reassuring markets and depositors of the solvency of European banks exposed to sovereigns.
This requires a pre-emptive recapitalisation that goes significantly beyond offsetting losses caused by a Greek restructuring, and builds in cushions that would allow banks to withstand additional sovereign debt restructurings, even if these are unlikely to occur.
- Liquidity provision, whose main objective is to subdue a panic, and maintain the funding costs of solvent sovereigns and banks within reasonable limits.
The Greek restructuring and recovery plan
Steps to realise these aims include:
- A Greek restructuring in the form of either a debt exchange offer or a change in domestic law that would allow majority bondholder decisions to be binding for minorities.
To both give an upside to creditors and help limit the fiscal impact of future recessions, GDP-indexed bonds should be a centrepiece of the menu of new debt that replaces the old. The restructuring needs to be embedded in a post-restructuring EU/IMF-supported programme that deals with any remaining sovereign financing needs while the sovereign remains cut off from capital markets. It must also encourage the continued implementation of reforms. The Greek banking system will require both recapitalisation and continued liquidity support.
Pre-emptive recapitalisation of Eurozone banks from national or EFSF funds
- Pre-emptive recapitalisation aimed at providing large capital buffers.
To break the link between the solvency of the banking system and the solvency of the sovereign, the recapitalisation should be undertaken through EFSF bonds in the EU/IMF programme countries, with flexibility to extend the EFSF-based recapitalisation to a few non-programme countries, such as Italy and Spain, that face either large funding or large fiscal adjustment challenges, or some combination of both.
Since a recapitalisation might strain fiscal space in these countries, they should be able to benefit from EFSF resources for the purposes of bank recapitalisation. Other EU countries can recapitalise their banking systems through using national public debt.
ECB continues to buy Eurozone sovereign debt
- In order to preserve the resources of the EFSF as a key instrument for bank recapitalisation – and possibly for additional direct crisis lending to sovereign should this become necessary – the main tool providing liquidity to prevent the overshooting of bond spreads and stabilise bank funding must for now remain ECB intervention in secondary markets.
This should be underpinned by letters of intent in which countries that are not in EU/IMF-supported programmes commit to a trajectory of fiscal and growth-oriented reforms. They should also be backed by understandings between cross-border banking groups, home and host country regulators, governments, and the ECB to ensure that the normal flow of funding between parents and subsidiaries is maintained.
These three key elements in the short-term support strategy could be backstopped by:
- Direct EU-IMF lending to additional countries, if this becomes necessary as a tool to close financing gaps while at the same time promoting fiscal and structural reform;
- central bank swap lines between the US Federal Reserve and the ECB and others to provide dollar liquidity and contain the spillovers from the Eurozone crisis.
Institutional reform: Credible Eurozone economic governance
Together with short-run stabilisation measures, EU leaders must offer a plan for addressing the root causes of the crisis and confront the potential moral hazard arising from the crisis response. This is necessary both to convince markets that fiscal problems will not simply resurface once stabilisation efforts dissipate, and to reassure a sceptical EU public that the large cross-border financial commitments that were necessary to bring this crisis under control will not be repeated, except in the context of clearly specified institutional arrangements which describe the circumstances and limit the extent of such commitments.
Breaking the link between sovereign and banking crises
In some countries that have come under pressure in sovereign debt markets – particularly Ireland and Spain – the origin of these pressures has been financial rather than fiscal, as private-sector liabilities turned into actual or potential sovereign liabilities. At the same time, spillovers from sovereign debt crises to cross-border banking system have been the principle cause of the spread of the crisis.
While recent reforms to unify and strengthen European regulation and supervisory institutions will go some way to create more financial systems that are both less likely to become the source of problems and more capable of withstanding shocks, these should be supplemented by reforms that specifically seek to de-link financial and sovereign risks:
- Protecting the banking system from the sovereign requires a cap on exposures (single obligor limits) with respect to sovereign debtors, including the sovereign in the home country of a banking group.
- Protecting the sovereign from the consequences of bank failures requires the creation of a European deposit insurance system, which ensures that the need to protect depositors and the payments system in the event of bank failures does not inevitably lead to a socialisation of these losses at the national level. This must be matched by an appropriate concentration of supervisory power at the European level.
None of these institutional reforms require a treaty change.
Ensuring fiscal responsibility
Reforms to strengthen fiscal and broader macroeconomic discipline have made progress both at the EU level, in the form of a new set of directives that strengthen and extend the Stability and Growth Pact, and at the national level, where several countries have begun to adopt fiscal rules designed to prevent excessive debt accumulation.
These efforts are welcome but unlikely to be sufficient, as penalty-based mechanisms to enforce fiscal good behaviour of sovereign countries are never fully credible, and there is no guarantee that national level reforms will be sufficiently comprehensive, timely, and universal. For this reason, EU leaders should consider additional medium-term reform initiatives in the following areas:
- Strengthening market discipline.
This could be done by (1) introducing ex ante limits to national debt levels beyond which the ESM would no longer be allowed to provide crisis lending; and/or (2) introducing a distinction between senior, EU-guaranteed debt up to a maximum national limit (for example, 60% of GDP, as proposed by Delpla and von Weizsäcker 2010) and junior, non-guaranteed debt beyond that limit. As countries increase their non-guaranteed debts, risk premia on these debts would rise much faster than is presently the case.
The effectiveness of both proposals relies on the credibility of the pre-set debt limits beyond which crisis lending or EU guarantees are no longer allowed. This would require a very strong legal anchor, mostly likely in the form of an EU treaty change.
- Delegating fiscal authority to the level of the Eurozone.
Conferring some degree of fiscal authority to a central institution is a more effective way of constraining national fiscal policies than imposing sanctions on countries after fiscal actions have been taken. There could be several models for this, ranging from giving powers to the European commission (or a new EU agency) to review and ask national authorities to amend budgets that result in excessive deficits before they become law, to an ECB-style institution that has the power to set the fiscal policy stance in Eurozone countries but without taking a position on the composition of taxes or spending, all the way to fully-fledged fiscal federalism, in which some spending and taxation decisions are taken at the EU level.
All these ideas would imply a significant shift of power away from national authorities, and would require a treaty change.
Managing the transition to stronger governance regimes
Some of the medium-term institutional reforms described in the previous section would have counterproductive effects in the short run. For example, establishing single obligatory limits with respect to home country sovereigns could force some banks that are heavily exposed to sovereign to reduce government bond holdings, adding to market pressure; or, alternatively, add to pressures to raise additional capital. Similarly, extending an EU guarantee to a portion of countries’ sovereign debts could imply that some countries lose market access on their non-guaranteed portions.
In principle, there are two ways in which these transition problems can be dealt with:
It is possible to move to the new regime gradually, by defining a transition period backed by incentives. Banks could be given a period to gradually adjust to the new limits, together with regulatory incentives for reaching the new ceilings early. Similarly, Eurozone-guaranteed debt could be introduced at the margin; as non-guaranteed debt is redeemed, newly-issued debt could consist of guaranteed and non-guaranteed bonds in a proportion that is linked to compliance with a fiscal programme, and designed to avoid dilution of long-term debt holders. At the end of this process, which could take many years, there would be a lower target debt stock composed mainly of guaranteed (up to the agreed limit) and possibly some non-guaranteed debt.
Transition could be achieved in one stroke through a stock operation. For example, banks whose single-obligor exposures to sovereigns exceed the new limits could be recapitalised through the EFSF. (In effect, this amounts to swapping home country sovereign debt with debt of other sovereigns.) Similarly, Eurozone-guaranteed debt could be introduced by having the EFSF (or a Special Purpose Vehicle) purchase sovereign debt of all Eurozone countries in excess of 60% of GDP, financed through the issue of common Eurozone bonds.
All countries that form part of this operation (meaning almost all Eurozone countries) would need to agree to medium-term (3-5 year) programmes that put their debt stocks on a downward path. Some countries may not be able to access the market using non-guaranteed debt issue during this period. In these cases, the EFSF (or Special Purpose Vehicle) would need to finance net debt issuance during the transition period.
Although the primary purpose of introducing guarantees in either approach is an orderly transition towards a system of stronger fiscal incentives, both approaches would also help to maintain financing for highly indebted sovereigns during the adjustment period. As such, they could complement the package of short-term stabilisation measures discussed earlier.
Editors' note: The views expressed in this note should not be taken to represent the views of the EBRD or the WEF.
Delpla, Jacques, and Jakob von Weizsäcker (2010), The Blue Bond Proposal, Bruegel, May.
1 This note is based on discussions held during the October 10-11 2011 World Economic Forum's Summit on the Global Agenda in Abu Dhabi. Contributions, comments and suggestions by Erik Berglöf, Adrienne Cheasty, Daniel Gros, Victor Halberstadt, Luisa Lambertini, Shuanglin Lin, Liana Melchenko, Zanny Minton-Beddoes, Helene Rey, Beatrice Weder, Peter Westaway and Ngaire Woods are greatfully acknowledged without implying agreement with any claims made in this note. The views expressed in this note should not be taken to represent the views of the EBRD or the World Economic Forum.