At its forthcoming meeting on 24-25 March the European Council will consider a comprehensive package of measures that it hopes will open a new age of European economic governance – with meaningful progress towards a compromise already achieved by the Heads of State and Government of the Eurozone last Saturday (see Gros 2011b on this site).
However, much confusion remains as to the common policies to tackle the sovereign debt crisis of “peripheral” Eurozone countries and the role of the new European Stability Mechanism (ESM). On this the Eurozone leaders have rightly decided to raise the amounts available under the common financial support facilities, as expected, but have not been able to agree on an adequate strengthening of the intervention capabilities of the ESM, and its temporary predecessor, the European Financial Stabilisation Facility (EFSF).
The decision to let these common funds purchase distressed debt directly from the issuers in all likelihood violates the no-bailout provision of Article 125 of the Treaty on the Functioning of the EU. And the minor concessions offered to Greece and Ireland to relieve their debt burden will achieve nothing in tackling their underlying solvency problem. And the attempt to press the Irish government to raise corporate taxation in exchange for lower rates on emergency financing is outright shameful.
As I argue with co-authors in a recent CEPS paper (Micossi, et al. 2011), it is high time for the European Council to stop ducking the issues and provide a credible framework to tackle the sovereign debt crisis in the Eurozone – or leave the EU and the euro once again at the mercy of short sellers.
Legal limits to financial assistance
Article 125 of the Treaty on the Functioning of the European Union contains the so-called “no-bailout” provision, whereby neither the EU nor a member state “shall be liable for or assume the commitments of” any public body or entity of any member state, “without prejudice to mutual financial guarantees for the joint execution of a specific project”. It does allow for the possibility of guarantees for a “joint project”, an expression that may well include financial assistance to a member state, provided:
(a) financial assistance is for the purpose of preserving collective financial stability, that is, avoiding unwanted systemic fallout from a local crisis; and,
(b) financial assistance does not result in a fiscal transfer to a member state.
The possibility of granting financial assistance to a member state is also recognised by Articles 143 (for non-euro member states) and 122.2 (for Eurozone members) of the Treaty. The amendment to Article 136 already decided by the European Council last December (cf. Council Conclusions, Annex I) should eliminate any remaining uncertainty in this regard.
Thus, the Treaty bans any direct fiscal transfers from one member state to another, in order to help the latter meet its debt obligations, as well as the assumption of guarantees for those liabilities. As a consequence, it seems also to ban any direct purchases of sovereign debt in the primary market, which could entail a direct assumption of the commitments of one member state.
On the other hand, the Treaty leaves broad room to grant financial assistance to the member states of the EU and the Eurozone in order to preserve systemic stability. Extending a loan to rollover sovereign debt as has been done, intervening in distressed markets to restore normal conditions, or exchanging Union bonds for sovereign debt held by the private sector provided these operations are undertaken at market prices, would all qualify as permissible acts of financial assistance.
The financial assistance programmes for Greece and Ireland have provided bridging finance for a limited period – until 2013 – but have not restored debt sustainability, only postponed the day of reckoning. Failure to address the issue of solvency with proper instruments will only exacerbate adjustment costs and raise the spectre of disorderly default, with high risks of financial fallouts on the entire Eurozone. Therefore, the EU urgently needs effective arrangements for debt restructuring.
Traditionally, two main approaches have been proposed to debt restructuring.
- A centralised statutory approach was prominently advocated by the IMF in the early 2000s (Krueger 2002), and requires a transnational unified legal bankruptcy framework and an international court to manage the procedure and adjudicate controversies in individual cases. However, this approach seems overly rigid and requires a degree of harmonisation of national bankruptcy laws that seems unfeasible.
- The alternative is a voluntary and market-based decentralised approach, which seems a better fit for the EU diverse legal systems. Under this approach, an EU directive or, better, a regulation could establish broad principles and guidelines to be followed in all sovereign debt contracts that would facilitate restructuring negotiations. In December 2010 the European Council already agreed that all sovereign bond issues by Eurozone countries should carry collective action clauses starting in June 2013.
Bank crisis resolution
Unsustainable sovereign debt accumulation by certain Eurozone governments is closely intertwined with reckless lending by core Eurozone banks. Restoring debt sustainability will not be feasible unless the banks take their share of losses on bad loans. On what to do about this we refer to the recommendations of a CEPS Report on bank crisis resolution (Carmassi et al., 2010), also a recent Vox column of mine (Micossi 2010).
Pretending that core Eurozone banks are not part of the solution, and weakening forthcoming stress tests to validate that claim, is a recipe for further instability which may be deeply regretted.
A number of schemes have been proposed to substitute Union bonds for national sovereign debts, with allegedly substantial gains for everyone stemming from credit risk and liquidity enhancement. It seems useful to distinguish between the schemes that apply to all Eurozone sovereign debt and those specifically targeted at easing the debt burden of distressed sovereign borrowers.
The former schemes typically envisage a large-scale substitution of national debts with jointly-issued bonds, up to a maximum ratio to GDP corresponding to some acceptable level of indebtedness (e.g. Delpla-von Weiszäcker 2010, Juncker–Tremonti 2010, Monti 2010), based on the assumption that there are substantial gains to be reaped, in terms of borrowing costs, from the creation of a large and deep market for Union bonds. Unfortunately, empirical evidence indicates that market spreads over the best (Triple A) bonds are mainly determined by credit risks, and that large liquidity gains are simply not there (Favero and Missale 2010). Moreover, any massive substitutions of Union for national bonds would seem to violate Article 125 of Treaty on the Functioning of the European Union since the conditions for financial assistance under the Treaty would not be met, and any such operation would amount to some degree to the joint assumption of liabilities for national public debts.
Similar difficulties do not arise when Union bonds are issued by EU institutions for specific common purposes stemming from the Treaty or recognised by legislation. For instance, the European Investment Bank issues bonds guaranteed by its capital, and ultimately by its members, to finance investment projects of common interest meeting statutory quality requirements. Its bonds clearly fall under the label of “joint execution of a specific project” in Article 125.
As has been argued, the decision to have the new ESM issue Union bonds to provide financial assistance to distressed members of the Eurozone may also be seen as a specific project in the sense of Article 125. The forthcoming amendment to Article 136 would eliminate all uncertainty in this regard – of course to the extent that the ESM activities would fully respect the “no-bailout” condition. This would be the case, for instance, with the Gros and Mayer (2011) proposal to open a window at the ESM where creditors may exchange national debt with ESM-issued Union bonds at prevailing market prices.
The European Stability Mechanism
We now have all the building blocks required to decide what the ESM should and should not do, consistent with the no-bailout Treaty prohibition but also the need to effectively resolve the debt crisis in the Eurozone and restore durable financial stability.
The ESM should be empowered to issue bonds for “the execution of a specific project” as under Article 125 and/or to grant financial assistance as under new Article 136 for Eurozone member states. Any operation undertaken by the ESM should not result in a fiscal transfer or a direct assumption of credit risk exposure to the member state concerned, or a guarantee for its liabilities.
Financial assistance to distressed sovereign debtors should go beyond providing temporary liquidity support and be granted for the period necessary to restore debt sustainability and normal access to private capital markets. To this end, adjustment programmes should explicitly assess debt sustainability and financing gaps, and provide a framework for debt restructuring when needed. The inclusion of debt sustainability among the conditions of financial assistance is key to respecting the no-bailout condition since it will ensure that the ESM will not take upon itself any sovereign debt liability; it will also reduce the probability of financial market turmoil due to weak credibility of adjustment programmes, as has been experienced in the recent past. On this, the heads of State or Government of Eurozone have agreed that any decision to provide financial assistance to a Eurozone member state will be taken by unanimity on the ground of a debt sustainability analysis conducted by the Commission and the IMF, together with ECB.
The ESM should also be entitled to intervene to help the member states recapitalise their banking system as required by emerging losses on restructured sovereign debts, keeping in mind that Europe’s banking system still is undercapitalised and exposed to new shocks (Gros 2011).
Finally, as has been suggested by Gros and Mayer (2011), the ESM should be allowed to swap its own liabilities with large volumes of distressed sovereign debt held in private portfolios, at current market valuation – which would be instrumental in facilitating voluntary debt restructuring of countries already under a financial assistance programme.
Should the ESM also be empowered to purchase distressed sovereign debt in the secondary market at times of acute market distress? Perhaps a better alternative would be to leave these operations in the hands of the ECB but enable the ESM to purchase sovereign paper in the ECB portfolio, at prevailing market prices, when market conditions do not allow the ECB to reverse its purchases in the market. The ECB would no longer be stuck with low-rating government paper, while the ESM would be able to dispose of them within the broader context of the financial assistance programme to that particular sovereign debtor.
Carmassi, J, E Luchetti, and S Micossi (2010), Overcoming too-big-to-fail: A Regulatory Framework to Limit Moral Hazard and Free Riding in the Financial Sector, CEPS Task Force Report, CEPS, Brussels, March.
Delpla, J and J Weizsäcker (2010), The blue bond proposal, Bruegel Policy Brief, Bruegel, Brussels.
Favero, CA and A Missale (2010), “EU public debt management and Eurobonds”, in Euro Area-governance Ideas for crisis management reform, European Parliament, September.
Gros, D. (2011a), “The EU’s Band-Aid on a Bullet Hole”, Project Syndicate, 4 March.
Gros, D (2011b), “Pact for the euro: Tough talk, soft conditions?”, VoxEU.org, 14 March.
Gros, D and T Mayer (2011), Debt reduction without default?, CEPS Policy Brief No. 233, CEPS, Brussels,.
Juncker, JC and G Tremonti (2010), “Eurobonds would end the crisis”, Financial Times, 5 December.
Krueger, A (2002), A New Approach To Sovereign Debt Restructuring, International Monetary Fund, Washington DC.
Micossi, Stefano, Jacopo Carmassi, and Fabrizia Peirce (2011), “On the Tasks of the European Stability Mechanism”, CEPS Policy Brief No. 235.
Micossi, S (2010), “A regulatory architecture for cross-border banking groups”, VoxEU.org, 16 March.
Monti, M (2010), “Titoli europei in aiuto all’euro”, Corriere della Sera, 2 December.