31 August 2015

CEP: A sovereign default regime for the euro area

Executive Summary 

Requirements for a solution

• A solution to the eurozone’s problems, and its survival, requires that all eurozone countries be once again allowed to make their own decisions regarding timing, type and scope of reforms. This is the only way to ensure that their economic culture and tradition are taken into account and that they do not feel as though they are under external control. However, it must not be possible for fiscal or economic difficulties in one eurozone country to trigger crises in other eurozone countries.
• Allowances can be made for the above problems by introducing a sovereign default regime for the eurozone countries. 
• The sovereign default regime must fulfil the following requirements:

(1) The enforcement of sovereign default must be credible.

(2) In the case of a sovereign default, national and international investors and the national voters in their capacity as taxpayers are exclusively liable, and not the taxpayers of other countries.

(3) Every country must be able to control its own fiscal, economic, labour market and social policies.

(4) Any developments that threaten the solvency of a country must become obvious at an early stage so that investors and voter have a chance to respond,

(5) Imbalances in the financial sector must not, in general, threaten sovereign solvency,

(6) Financial institutions must be able to cope with the sovereign default. 

The elements of a sovereign default regime for the eurozone countries

• The key element: Early, automatic haircut. If the debt level of a eurozone country reaches 90% of GDP (reference value), a haircut of 10% will be triggered automatically. Controlled default with a small haircut will be enforced early on instead of uncontrolled default. This has the following advantages:

(1) Investors can form clear expectations about their risk of loss. [...]

(2) Gradually increasing spreads lead to a slow but constant increase in the pressure for reform. This gives the government time to make corrections. [...]

(3) If a state approaches the reference value, credit financing becomes more expensive for businesses and consumers, too. They will thus have sufficient time and opportunity, at the latest when it comes to the next election, to inform their politicians of their preferences.

(4) Existing incentives to delay default as long as possible, thereby raising the default costs, are eliminated.

• Transitional arrangements for eurozone countries whose debt level amounted to more than 75% of GDP in 2014. [...]
• Accompanying measures to prevent new debt via the ECB’s TARGET system. [...]
• Accompanying measures to (partially) shield governments from the default of financial institutions. [...]
• Accompanying measures to shield financial institutions from sovereign defaults. [...]
• Consequences for the existing precautions to safeguard the solvency of eurozone countries.

(1) The Stability and Growth Pact is superfluous and can be abolished.

(2) Apart from direct bank recapitalisation, the European Stability Mechanism (ESM) will otherwise only grant loans to countries or to the Bank Resolution Fund for the recapitalisation of banks. The traditional loans to countries, generally used until now to prevent sovereign default, will no longer be possible.

Full analysis paper

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