Designing a sovereign debt crisis resolution mechanism for the Eurozone

1. Designing a sovereign debt crisis resolution mechanism for the Eurozone Presentation at UNCTAD-Columbia conference on resolution of debt crises Jeromin Zettelmeyer, EBRD* February 2011 *Speaking in private capacity

2. The challenge Design a crisis resolution mechanism that: • Allows for the orderly (and relatively painless) resolution of debt crises • Creates incentives that help prevent such crises • Is well integrated into the broader system of EU and Eurozone surveillance and economic governance (SGP and extensions). • Note that there may be a trade-off between 1 and 2 (the “Dooley problem”).

3. The state of the debate • Most proposals call for some form of formalised debt workout mechanism • either by statute (SDRM) • or via debt contracts (CACs) Examples: Bruegel EDRM proposal (Gianviti et al); CESIfo proposal; ESM proposal • The argument: these mechanisms make debt crises tractable, hence constitute a credible alternative to a bailout, and hence activate market discipline in support of EU fiscal rules.

4. Some quotes that illustrate the argument • “Above all, it is necessary to develop a procedure for orderly state insolvency; this would provide a powerful incentive for Eurozone members to keep their finances in order.” (Angela Merkel, speech to the German Bundestag 19.5.2010). • “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.” (Daniel Gros and Thomas Mayer, VoxEU, 15 March 2010).

5. But would it work? Rest of this talk • A reminder of what formalised workout mechanisms would be expected to do • A brief review of what the experience with sovereign debt crises since 1998 tells us about the likely effects of these mechanisms • Three ways in which the mechanisms could be applied; three different views on their usefulness Bottom line: • These mechanisms will not help by themselves. It depends on their design and relationship to other elements of EU economic governance.

6. SDRM – what it consists of • An activation mechanism • typically, but not necessarily,SDRM is invoked by debtor country • A mechanism for electing creditor representatives • Possibly, stay of payments and litigation while negotiations take place • Possibly, access to emergency (“DIP”) financing during negotiations • After negotiations have concluded, deal becomes binding for all creditors – solves “holdout problem”.

7. CACs – what they consist of • At a minimum, a contractual provision for making a change in payment terms agreed between a (qualified) majority of creditors and the debtor binding on all creditors. • Bond-by-bond • In principle, could be supplemented by provisions that relate the new payment terms to the restructuring of other bonds (“aggregation clauses”). • Could not be applied to the existing stock of debt without such clauses (unless there is a debt exchange; or by statute).

8. Assumed effects • Reduce (CACs) or eliminate (SDRM) collective action problem in debt restructurings (in particular, holdout problem) make restructurings faster and more orderly reduce the cost of restructurings make them palatable as alternative to bailouts instill market discipline ex ante. Should we believe this? • Look at what we can learn from past sovereign debt crises

9. Past lessons (1): costs of defaults Two main channels • Temporary exclusion from capital markets • In general, only while country is in default • Domestic spillovers • Interdependency between sovereign and banking system can lead to financial collapse • Generalised loss in confidence (“the rules of the game”) can lead to “secondary runs” and collapses in investment Result: domestic output costs • Caveat: hard to disentangle cause and effects

10. Past lessons (2): collective action problems in debt restructurings Much milder than expected. • Reasonably quick, high participation (except Argentina) • “Holdout creditors” did not block any restructurings (even in Argentina). Interpretation: • debt exchanges plus minimum participation thresholds, • offers in line with capacity to pay

11. So … • SDRM/CACs likely to be good at something that turns out not to have been a big problem • SDRM/CACs likely not very good at reducing the real costs of debt crises (domestic spillovers; effects on financial system). Next, examine likely effectiveness of various versions of a Eurozone (or EU) debt crisis resolution mechanism (DCRM)

12. Would it make a difference? Variant 1: a debtor-invoked EU-DCRM No: It would not be invoked! Why? • Because in the presence of a DCRM, debt restructurings are likely to be only mildly more attractive, from the debtor country perspective, than they are today.

13. Would it make a difference? Variant 2: an EU-invoked EU-DCRM No: It still would not be invoked! Why? • Since DCRM is not very good at addressing actual costs of default, it does not address the contagion problem! • Markets worry about next DCRM-candidates • Insolvency could become self-fulilling • DCRM does not significantly affect costs of default of these next candidates • Consequently, these countries will support bailouts that prevent activation of the DCRM for fear of contagion.

14. Would it make a difference? Variant 3: EU-DCRM with precommitment • Example for precommitment: DCRM enshrined in EU law as only legal workout/bailout mechanism for Eurozone countries • This would make a huge difference: Market discipline boosted; spreads of fiscally weaker countries would rise sharply at a much earlier stage, much lower debt ceilings. • But: very inefficient. Countries forced into DCRM even in pure bad-luck crises. Debt ceilings too low. Quite possibly, worse than the status quo.

15. Would it make a difference? Variant 4: EU-DCRM with precommitment and ex-ante conditionality • Examples: DCRM enshrined in EU law as only legal crisis resolution mechanism for countries: • which fail to meet certain objective criteria (e.g. debt/GDP > X percent; below this access to crisis lending); OR • for whom EC has previously recommended a sanction under the excessive deficit procedure • Higher borrowing costs for such countries • Not fully efficient because countries could may not meet criteria due to bad luck • But: reasonable compromise between incentives and insurance.

16. How does Variant 4 compare with the ESM proposal (November 2010)? • Superficially, a similar idea: crisis lending for illiquid countries, debt restructuring (based on CACs) for unsustainable debt cases. • But: no ex ante criteria defining which “treatment” applies when • Instead, decisions taken by European council. • This is basically Variant 2. Conditioning help on debt restructuring not fully credible. At the same time, no predictable safety net for good performers.

17. Conclusion • An EU-DCRM could be a good idea if combined with a standard crisis lending facility (preferably, a less political version of the EFSF) • But need pre-commitment to make it effective. Discretionary ex-post activation not credible • Pre-commitment rules need to be sensibly designed to provide good incentives and at the same time insurance against bad shocks. • Credibility of international pre-commitments is always an issue. But if there is a place where common institutions and legal frameworks can help overcome that issue, it is the EU.