Big financial crises are usually followed by pressure on public debt and often by sovereign default (Rogoff and Reinhart 2009). Europe, or rather the Eurozone, was caught totally unprepared for this second phase of the crisis.
Members of the Eurozone were supposed to be shielded from a financial market meltdown. But, after excess spending during the period of easy credit, several Eurozone members are now grappling with the implosion of credit-financed construction and consumption booms. Greece is the weakest of the weak links, given its high public debt (around 120% of GDP), compounded by a government budget deficit of almost 13% of GDP, a huge external deficit of 11% of GDP and the loss of credibility from its repeated cheating on budget reports. But other Eurozone members are in a similar position (Gros 2010).
Proposing a European Monetary Fund
We provide here a concrete proposal for how the EU (or rather the Eurozone) could deal with sovereign default by creating a European Monetary Fund (EMF), which would be capable of organising an orderly default as a measure of last resort. We also show how its funding could be structured in a way to minimise moral hazard.
Our proposal complement the current ideas for allowing orderly defaults of private financial institutions and rescue funds for large banks that would be funded by the industry itself. The analogy holds in more general terms. In the recent financial crisis, policy has been geared solely towards preventing failure of large institutions. In the future, however, the key policy aim must be to restore market discipline by making failure possible. For the Eurozone this means that the system should be made robust enough to minimise the disruption caused by the failure of one of its member states.
Key issues for the design of a European Monetary Fund
The proposed fund could be set-up under the concept of “enhanced cooperation” established in the EU Treaty and could be a concrete expression of this principle of solidarity.
Any fund with a mutualisation of risks creates a moral hazard because it blunts market signals. This would argue against any mutual support mechanism and reliance on financial markets to enforce fiscal discipline. However, experience has shown repeatedly that market signals can remain weak for a long time and are often dominated by swings in risk appetite which can be quite violent. In reality, the case for reliance on market signals as an enforcement mechanism for fiscal discipline is quite weak. In fact, swings in risk appetite and other forces that have little to do with the credit-worthiness of a country can lead to large swings in yield differentials and even credit rationing that have little to do with economic fundamentals; and often come too late and in such an abrupt fashion as to make an orderly impossible.
The moral hazard problem can never be completely neutralised, but for our proposal it could be limited in two ways; through the financing mechanism of the EMF and through the conditionality attached to its support. These points will be discussed first, followed by a brief analysis of two equally important issues, namely enforcement through the threat of orderly default.
A simple mechanism to limit the moral hazard problem would be the following: the main contributions should come from those countries that breach the Maastricht criteria. The contribution rates would be calculated on the following bases:
- One percent annually of the stock of “excess debt”, which is defined as the difference between the actual level of public debt (at the end of the previous year) and the Maastricht limit of 60% of GDP. For Greece in 2008 with a debt-to-GDP ratio of 115%, this would imply a contribution to the EMF equal to 0.55% of GDP.
- One percent of the excessive deficit, i.e. the amount of the deficit for a given year that exceeds the Maastricht limit of 3% of GDP. For Greece, the 2009 deficit of 13% of GDP would give rise to a contribution to the EMF equal to 0.10% of GDP.
Thus, the total contribution for Greece in 2009 would have been 0.65% of GDP, substantial, but still bearable in this difficult time.
The contributions should be based on both the deficit and the debt level because both represent warning signs of impending insolvency or liquidity risk (this is also the reason why both were included in the Maastricht criteria and both matter for the Stability Pact, although in practice the debt ratio has played less of a role). If applied since 1999 the contributions based on the debt level would have made a significant contribution, illustrating how this mechanism could limit moral hazard and help build up a substantial fund.
It could be argued that contributions should be based on market indicators of default risk rather than the suggested parameters. But the existence of an EMF would depress CDS spreads and yield differentials among members, making such a procedure impossible.1
Until EMF funds reach a certain threshold it should be given the authority to borrow in the markets. Contributions would be invested in investment-grade government debt of Eurozone member countries. Debt service (in case funds had to be raised in the market) would be paid from future contributions.
Countries with exceptionally strong public finances would not need to contribute because they would de facto carry the burden should a crisis materialise. Their backing of the EMF (and the high rating of their bonds in its portfolio) would be crucial if the new institution were called into action. This is similar to the IMF; all countries contribute pro rata to the financing of the IMF, which enables it to lend to provide financing to those member countries in need because of balance-of-payments problems.
There should be two separate stages:
Stage I: Any member country could call on the funds of the EMF up to the amount it has deposited in the past (including interest), provided its fiscal adjustment programme has been approved by the Eurozone.2 For Greece this would already amount to about €10 billion if the EMF had been created from the start of the EMU.
Stage II: Any drawing on the guarantee of the EMF above this amount would be possible only if the country agrees to a tailor-made adjustment programme supervised jointly by the Commission and the Eurozone.
With the EMF in operation, a crisis would be much less likely to arise. However, should a crisis arise the EMF could swing into action almost immediately because it would not have to undertake any large financial operation beforehand. A public finance crisis does not appear out of the blue. A member country encountering financial difficulties will have run large deficits for some time and its situation will thus have been closely monitored under the excessive deficit procedure.
The EU has a range of enforcement mechanisms in case the country in question does not live up to its commitments. As a first step, new funding (guarantees) would be cut off. This is standard but the EU can do much more. Funding under the structural funds could also be cut off (this is already foreseen, in a weak form, under the Stability Pact) as well. For a country like Greece, this could amount to about 1-2% of GDP annually. Finally the country could effectively be cut off from the Eurozone’s money market when its government debt is no longer eligible as collateral for the ECB’s repo operations. The key point here is that these sanctions can be applied in an incremental manner and that they impose considerable economic and political costs on any country contemplating not implementing a previously agreed programme.
The strongest negotiating asset of a debtor is always that default cannot be contemplated because it would bring down the entire financial system. This is why it is crucial to create mechanisms to minimise the unavoidable disruptions resulting from a default. Market discipline can only be established if default is possible because its cost can be contained.
A key point of our proposal is that the EMF could also manage an orderly default of a Eurozone country that fails to comply with the conditions attached to an adjustment programme. A simple mechanism, modelled on the successful experience with the Brady bonds, could do the trick. To safeguard against systemic effects of a default, the EMF could offer holders of debt of the defaulting country an exchange of this debt with a uniform haircut against claims on the EMF.
This would be a key measure to limit the disruption from a default. A default creates ripple effects throughout the financial system because all debt instruments of a defaulting country become, at least upon impact, worthless and illiquid (for more on default risks, see Biggs et al., 2010). However, with an exchange à la Brady bonds, the losses to financial institutions would be limited (and could be controlled by the choice of the haircut).
How drastic should the haircut be?
The Maastricht fiscal criteria offer again a useful guideline. The intervention of the EMF could be determined in a simple way. The EMF could declare that it would only be willing to invest an amount equal to 60% of the GDP of the defaulting country. In other words, the haircut would be set it in such a way that the amount the EMF has to spend to buy up the entire public debt of the country concerned is equal to 60% of the country’s GDP. This would imply that for a country with a debt to GDP ratio of 120%, the haircut would be 50% as the EMF would “pay” only 60/120. Given that the public debt of Greece is now already trading at discounts of about 20% (for longer maturities) this would mean only a modest loss rate for those who bought up the debt more recently. Of course, the size of the haircut is also a political decision that will be guided by a judgement on the size of the losses creditors can bear without becoming a source of systemic instability. But uncertainty could be much reduced if financial markets are given this approach as a benchmark based on the Maastricht criteria.
In return for offering the exchange against a haircut, the EMF would acquire the claims against the defaulting country. Going forward, the latter would then receive any additional funds from the EMF only for specific purposes approved by the institution. Other EU transfer payments would also be disbursed under strict scrutiny, or they could be used to pay down the debt owed by the defaulting country to the EMF. Thus, the EMF would provide a framework for sovereign bankruptcy comparable to the Chapter 11 procedure existing in the US for bankrupt companies that qualify for restructuring. Without such a procedure for orderly bankruptcy, the EU could be taken hostage by a country unwilling to adjust, threatening to trigger a systemic crisis if financial assistance is not forthcoming.
Member states of the EU remain sovereign countries.
A defaulting country may regard such intrusion into its policies by the EMF as a violation of its sovereignty and hence unacceptable. But an EU member country that refused to accept the decisions of the EMF could leave the EU, and with this the EMU (See ECB 2009 for legal issues).The price for doing so would of course be much greater than that exacted in the case of the default of Argentina. If a country refused all cooperation and did not leave the EU on this own, it could effectively be thrown out by recourse to Article 60 of the Vienna Convention on International Treaties, or Article 7 of the Treaty of Lisbon could be invoked.
We argue that setting up an EMF to deal with Eurozone member countries in financial difficulties is superior to the option of either calling in the IMF or muddling through on the basis of ad hoc decisions. Without a clear framework, decisions about how to organise financial support typically have to be taken hurriedly, under extreme time pressure, and often during a weekend when the turmoil in financial markets has become unbearable.
Our proposal is not meant to constitute a ‘quick fix’ for a specific case. Greece is the problem today, but it will not go away quickly. The experience of Argentina shows that default arises only after a period of several years in which economic and political difficulties interact and reinforce each other. Failure is not inevitable, as the relatively successful experience so far with tough adjustment programmes in Ireland and Latvia are showing. But what is unavoidable is a considerable period of uncertainty. With an EMF, the EU would be much better prepared to face these difficult times.
Note: The authors would like to thank Michael Emerson and Stefano Micossi for helpful comments and Cinzia Alcidi for valuable research assistance.
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1 Something else would reinforce graduated pressure on countries with weak fiscal policies: an adjustment of the risk weighting under Basel II. The risk weight for government debt is at present 0 for governments rated AAA to A, and only 20% until A- (implying that banks have to hold only 0.2*8% = 1.6% of capital against holdings of the debt of governments which might have lost over 10% in value. There is no reason why euro area government debt should have a systematically lower risk weighting than corporate debt, for which the risk weights are 20% and 50%, respectively.
2 In formal terms this would mean that the country is faithfully implementing its programme and that no recommendation under Article 126.7 has been formulated within the excessive deficit procedure.