VoxEU: Revisiting sovereign bankruptcy

12 November 2013

If the euro is to survive, this will require better ways to resolve debt crises and stronger, market-based incentives that prevent debt problems from occurring in the first place.

Authors: Lee C Buchheit , Beatrice Weder di Mauro, Anna Gelpern, Mitu Gulati, Ugo Panizza, Jeromin Zettelmeyer

The authors argue:

• Pre-crisis policy mistakes, and in particular the tendency of domestic policymakers to overborrow, or pay too little attention to private debt accumulation that might turn public, are now recognised to be a much more severe problem for borrowing countries than the costs or limited availability of private financing. Far from being a problem, proposals that would limit the ability to borrow for countries with poor policies are a good thing.
• Recent court rulings complicate efforts to resolve future debt crises on an ad hoc basis – particularly a US ruling that gives ‘holdout creditors’ the right to interfere with payments to the creditors that accept such an offer.
• Sovereign debt crises are no longer just a problem in emerging markets, but a core concern in advanced countries as well – particularly in the eurozone.

Eurozone policy proposals

The eurozone differs from other integrated regions in both that its members have fewer instruments to deal with debt crises – they cannot devalue or inflate – and because a crisis in one member can have catastrophic consequences for others (by threatening the common currency). This requires both a mechanism for the orderly resolution of debt crises, and stronger incentives to prevent them.

The current financial architecture in the eurozone is inadequate in this respect, because its main pillar – the European Stability Mechanism (ESM) – is not set up to deal with unsustainable debt. If it is used even when there are significant concerns about the ability of borrowers to repay their debts, it will become source of transfers, rather than just crisis lending.

These problems could be addressed via an amendment of the ESM treaty that encourages and legitimises – both legally and politically – debt restructuring in unsustainable debt cases.

• First, assets and revenues of countries undertaking a debt restructuring would be deemed immune from legal action by holdouts, if a restructuring is approved by the ESM.
• Second, the treaty would require a debt restructuring as a condition for ESM lending when national debts exceed a pre-set level.

This should be higher than the Maastricht limit of 60 per cent of GDP, but not so high as to render the constraint meaningless. In the eurozone, this may mean a level of about 1½ times the Maastricht limit. The presence of such a debt threshold would help differentiate borrowing costs in normal times based on the strength of economic policies. At the same time, it would protect ESM resources and eurozone taxpayers, and prevent extreme adjustments of public finances at the expense of citizens who usually have little control over policy mistakes leading to excessive sovereign debt.

Importantly, eurozone countries must be given a chance to deal with legacy debt before this regime is introduced. For countries significantly above the future upper debt threshold, this will require a judgement of whether debt can be reduced below the limit within a reasonable time frame. Where the answer is no, the eurozone needs to make a choice between an upfront restructuring – backed by the ESM – and extra support, for example, in the form of providing a joint and several guarantees on new debt issuance, as long as countries adhere to an agreed fiscal consolidation path.

Concluding remarks

The world is currently less equipped to handle problems of unsustainable debt than at any time since the 1930s. At the same time, the extent of these problems has grown. Reform proposals that could address them have become more mature and more targeted, and arguments that led to the rejection of analogous proposals ten years ago no longer apply. It is time for policy-makers to tackle the central problems head on.

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