Tackling sovereign debt crises more effectively

During the course of the financial and sovereign debt crisis, a number of new mechanisms were created in the European monetary union to coordinate and overcome crises. This resulted in the joint liability of the member states being extended, whilst, at the same time, allowing them to remain largely accountable for their own financial and economic policies. However, this mismatch between liability and control creates misguided incentives for policymakers and financial market players. In its latest Monthly Report, the Bundesbank presents a number of different approaches, which could contribute towards strengthening individual national responsibility as well as help avert and combat sovereign debt crises more effectively in future.

Since 2012, the European Stability Mechanism (ESM) has been in place as a permanent assistance fund to provide member states facing acute financing problems with temporary liquidity assistance in cases where the financial stability of the monetary union is at risk. This gives a member state more time to implement the necessary economic and fiscal reforms in order to restore a sustainable financial situation. To this end, a target-oriented reform and adjustment programme is agreed with the member state, which is also intended to ensure that it is able to repay the financial assistance. As a general rule, the fund is only able to grant financial assistance if a member state is experiencing temporary liquidity problems and the state is not fundamentally insolvent or unwilling to repay its debts. It is often difficult to make this distinction under potentially considerable time pressure when a member state is facing acute financing problems.

At present, the ESM finances both ongoing deficits as well as extensive redemptions of government bonds which are due to mature over the course of the programme. This way, investors are released from their liability and considerable risks are transferred to the taxpayer. This also results in the available funding volume becoming heavily depleted. In order to alleviate these problems, the Bundesbank proposes, among other things, that the design of government bond issues be adapted in future.

Make decisions based on more certain outlook

The Bundesbank economists advise stating in the contractual terms for bonds that the maturities of sovereign bonds will automatically be extended by three years, for example, as soon as an ESM programme is agreed for a member state. In such a case, adjustment measures would be agreed and their implementation monitored, but the bondholders would not be absolved from their liability. The decision whether or not to restructure the sovereign debt – a step which might be required under certain circumstances – could then be made during the course of the programme, when a clearer picture emerges of the macroeconomic and fiscal outlook of the member state. The Bundesbank believes that this would considerably reduce the level of ESM funds deployed for a single assistance programme. According to the Monthly Report article, the ESM's clout and credibility as a stability mechanism would thus be boosted.

Facilitate agreement between debtors and creditors if need be

The Bank's economists believe that there is a need to further adjust the collective action clauses for bonds. They state that the standardised procedure introduced in 2013 harbours the risk of individual investors that have acquired a sufficiently large share of a bond series blocking the restructuring of their bond and potentially insisting that their claims are met in full. According to the Bundesbank, the associated misguided incentives could be considerably reduced by introducing single-limb aggregation clauses, under which a qualified majority of creditors could trigger a debt restructuring that is binding for all creditors. This would simplify and accelerate the procedure if a debt restructuring is unavoidable. Creditors would then no longer have to fear that the restructuring burdens would be shifted to the rest of the creditor community as a result of individual investors opposing the debt restructuring. 

Ensure orderly and transparent process

The Monthly Report article goes on to say that it makes sense for a reliable and transparent procedure to define in advance how to proceed if a government is found to be overindebted. As things currently stand, the ESM is not in a position to monitor any restructuring measures, even though this might be a prerequisite for the disbursement of financial assistance. Bundesbank economists believe that this could be rectified by a reform. A more orderly procedure could create planning certainty and help to keep friction losses, the macroeconomic costs and thus also any haircut to a minimum. Under such an orderly procedure, coordination tasks could be entrusted to the ESM. The Bundesbank's Monthly Report article states that, to this end, the rights and obligations between the member states, creditors and the ESM would have to be laid down and a concrete timetable drawn up detailing when the individual steps in the procedure should take place.

The authors believe that the proposed reforms have the potential to enhance the member states' own responsibility, curb joint liability and significantly boost the clout of the ESM. This would render future sovereign debt crises less likely. However, they do not present a direct or simple solution for the member states' – in some cases – very high sovereign debt. As the Bundesbank emphasises in its Monthly Report, the member states should use the time available to implement the consolidation course that has already been agreed and make their public finances more crisis-resilient. At the same time, the report states that there is also a need to implement further reforms aimed at limiting the negative interplay between distress in the financial system and public finances on a sustainable basis.