21 July 2016

VoxEU: Creditor participation clauses - Making orderly sovereign debt restructuring feasible in the Eurozone

This column proposes a mechanism to allow for orderly restructuring of sovereign debt as part of ESM programmes. If debt exceeds certain thresholds, the mechanism triggers an immediate maturity extension. In a second stage, a deeper debt restructuring could follow.

The fiscal rules in the Eurozone are designed to constrain fiscal policy so that sufficient buffers exist for countries to weather shocks. However, incentives to obey the rules have been low, due to weak enforcement. This means a reccurrence of sovereign debt crises still cannot be excluded from the realm of possibilities. As a result, it is advisable to prepare for such unfortunate situations in advance. [...]

A restructuring mechanism would incentivise creditors to pay more attention to crisis risks, and to demand appropriate risk premiums on government bonds. In turn, this could discipline governments and their budget policies. This rationale is similar to the recently introduced bail-in rules for the banking sector.

In case of a crisis, the mechanism would reduce uncertainty by setting out clear processes and rules. It would reduce deadweight losses vis-à-vis the current system, in which the restructuring of privately held sovereign debt is carried out ad hoc, as happened in Cyprus and Greece.

A mechanism to regulate sovereign debt restructuring would also spread the adjustment burden more evenly between creditors and taxpayers. The crisis funds retained by not repaying creditors immediately could be reallocated to finance macroeconomic adjustment programmes with longer durations, leaving more time for reforms and reducing procyclical fiscal austerity.

How the mechanism works

We have developed a mechanism that draws on previous proposals for the Eurozone (see Andritzky et al. 2016 for a survey). Like many others, we propose that the mechanism should only be applied as part of an ESM programme. This would help to deter governments from free-riding on debt relief and encourage them to put their fiscal policies on a sustainable footing. Like other proposals, ours proposes debt restructurings are implemented through Collective Action Clauses in debt contracts. We envision a version of these called ‘Creditor Participation Clauses’ (CPCs). They are based on a single limb vote, ensuring aggregation across all debt containing CPCs.

At the start of a crisis, it is hard to distinguish between a mere funding crisis and a full-blown solvency crisis. While the latter requires a reduction of the debt burden, the former can usually be overcome through maturity extensions and interim funding, such as that provided by the ESM. In our proposal, a two-stage mechanism would avoid having to make this fateful decision at the onset of a crisis, when uncertainty is high and the line between funding and solvency crises are blurred. Our proposal puts these two possible debt operations in sequence, as the liquidity need is eminent at the start of the crisis while the question of solvency cannot be reliably assessed until later.

As is already the case today, access to ESM credit facilities would require an assessment of public debt sustainability (ESM Treaty Article 13 1.b). Since it is in the ESM’s own interest to ensure repayment, the preparation of a debt sustainability analysis and the decision to invoke the restructuring mechanism would rest with the ESM. The ESM would trigger a restructuring in two stages:

• In stage one, we propose a fast and simple decision to trigger a maturity extension, avoiding delays and lingering uncertainty. According to our proposal, a maturity extension would be required if debt featuring CPCs exceeds 60-90% of GDP, or its refinancing volume exceeds 15-20 % of GDP. In addition, two to three or more violations of fiscal rules in the preceeding five years would trigger a maturity extension.
• In stage two, the ESM would decide whether to demand negotiations for a deeper restructuring in the course of the programme, using a more comprehensive set of considerations. It would also determine what extent of debt relief these negotiations would need to achieve. While there would be no need for a set timeline for the second stage, any deeper restructuring would necessarily have to take place while the standstill was still in effect.

While thresholds for debt stock and financing requirements are common, we favour including compliance with fiscal rules as an additional evaluation criterion for first-stage restructuring. A country’s track record under existing fiscal rules is an indication of its economic and political capacity to deliver fiscal adjustment. Including past compliance could also ex ante incentivise governments to adhere to fiscal rules. To reduce threshold effects, we propose a range that provides some (limited) discretion to policymakers, guided by technical analysis of the ESM. Using simple and hard-to-manipulate criteria should nevertheless prevent judgements from being distorted too heavily by political considerations.

How the mechanism could be introduced

A key advantage of our proposal over others is the ease with which it could be introduced. As opposed to more heavy-handed approaches, our mechanism builds on the existing ESM Treaty, which demands that private sector involvement be considered (Preamble 12, ESM Treaty). All that would need to be amended are ESM guidelines that make ESM lending conditional on our new, two-stage mechanism.

Also, the mechanism would become effective over time, as countries slowly replace existing debt with a new class of debt including CPCs. [...]

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