European sovereign debt crisis

09 March 20111 - Position of the Association of German Banks on the European sovereign debt crisis

1. Return to the capital market must remain medium-term target
The emergence and evolution of the European sovereign debt crisis have clearly underlined that it is investor confidence or non-confidence which ultimately creates the real pressure for economic-policy action. The aim of all measures should therefore be restoring the ability of highly indebted eurozone countries to access the capital markets at reasonable interest rates through a firm reform and consolidation policy. To achieve this, the further measures now to be adopted need to be packaged in a simple, transparent and convincing concept. The current support for highly indebted eurozone countries is therefore designed mainly to first stabilise the situation in order to win time for longer-term reforms.

2. Broad approach required
A sustainable solution to the sovereign debt crisis is only possible by means of a comprehensive package optimally combining short-term rescue measures and long-term reform efforts.

Long-term reforms require in particular

1. comprehensive consolidation efforts as well as growth-promoting structural reforms in  heavily indebted eurozone countries;
2. effectively strengthening the European Stability and Growth Pact, coupled with improved control and enforcement of the stability rules;
3. closer financial-policy and macroeconomic coordination between the eurozone countries;
4. a permanent crisis management mechanism enabling investors to adjust early to the conditions under which action will be taken in the future; the prerequisite for this is, however, orderly and transparent public finances in all the countries involved;
5. clear-cut, transparent rules for issuers and investors on the future structure of the sovereign bond market; the creation of too many different instruments and asset classes should be avoided so as not to undermine investor confidence;
6. a strong financial sector, as only a strong financial sector can absorb the losses resulting from sovereign debt restructuring without endangering the sector as a whole. At the same time, the possibility that individual institutions may nevertheless fail reinforces the disciplining function of the capital markets. For this reason, efforts to strengthen the financial sector along with banking regulation which ensures that large, complex financial institutions may also fail should be part of the comprehensive package.

A start has already been made in many of these areas. Work now needs to be carried on quickly with the aim of regaining investor confidence.

3. Avoid disorderly default
Until the onset of the sovereign debt crisis, eurozone sovereign bonds were awarded high ratings. They are consequently used on a large scale by investors who attach great importance to safety (capital preservation), e.g. pension funds, insurance companies and risk-averse retail clients, and also serve as cover for Pfandbriefe (German mortgage bonds). In addition, they enjoy advantages as collateral for central bank loans and receive preferential treatment under prudential capital requirements. This, too, explains why banks have relatively large holdings of eurozone sovereign bonds.

Eurozone sovereign bonds are therefore a particularly sensitive asset class. In the event of disorderly default on these, severe turmoil on the financial markets and serious difficulties in the banking system, which has not yet fully recovered from the financial crisis, would be likely. Moreover, not only countries directly affected by any disorderly default, but also those countries that would be indirectly affected by the resulting general loss of confidence would have only limited capital market access for a long time. This is likely to endanger elementary public payments and services in many eurozone countries.

4. Possible purchase of sovereign bonds as part of rescue measures
Expanding the mandate of the European Financial Stability Facility (EFSF) so that it can also buy sovereign bonds of heavily indebted eurozone countries on the secondary market or provide loans to these countries to enable them to repurchase their own sovereign bonds is worth considering. A direct advantage would be that the European Central Bank (ECB) could then withdraw from its own sovereign bond purchase programme launched last May and concentrate again on its key function of steering monetary policy. Market uncertainty about the ECB’s motives for taking action in the future would also be reduced at the same time.

To perform such an expanded mandate, the EFSF needs to have additional resources. The advantage of the direct repurchase of sovereign bonds by countries using EFSF loans is that, since bond prices would be below par value, it would lead to a reduction in the level of debt and thus to an improvement in the debt sustainability of the country concerned in each case. If sovereign bonds were purchased by the EFSF on the secondary market, there would be no such effect – there would merely be a “creditor swap” that does not initially alter the debt situation of the country concerned unless the full difference between par value and purchase price is immediately distributed to the country in need of support.

A purchase or repurchase programme should not be allowed to exercise any coercion. Coercive measures might be viewed effectively as default: due to speculative conclusions about similar behaviour by other eurozone countries, the risk of contagion would be enormous. Because of the required voluntariness, it is naturally unclear to what extent the repurchase programme would be accepted. The scale of potential debt reduction should therefore not be overestimated. A repurchase programme would, however, already be a help by allowing risk-shy investors to close their risk positions at a calculable price.

5. Collective Action Clauses are in principle a sensible tool
The European Stability Mechanism (ESM), which is to replace the EFSF from 2013, provides for the inclusion of Collective Action Clauses (CACs) in the terms and conditions of all new EU sovereign bonds. CACs therefore establish a legal framework for a sovereign debt restructuring process. They provide the basis for debt restructuring negotiations and can facilitate debt restructuring for bonds with heterogeneous groups of creditors, e.g. by reducing the risk of “free-riding ” by means of majority decisions. 

To avoid any unnecessary fragmentation of asset classes and resulting liquidity handicaps on the markets, the aim should be standardisation and closer coordination of this tool. Completely identical CACs cannot be a realistic target – what is required instead is comparability of the key CAC elements, e.g. a uniform quorum and uniform approval mechanisms.

In addition, CACs that are already known to investors when they purchase sovereign bonds would strengthen the important risk-yield mechanism and thus more or less automatically reinforce the pressure for budgetary discipline at the same time. Existing bonds that are subject to the national law of the issuer might be provided with CACs even without the consent of creditors through an amendment of national legislation. Yet such an approach would very probably also cause serious market dislocation.

CACs merely make debt restructuring negotiations easier per se, however. These negotiations must not relieve the ESM, i.e. the eurozone countries and the International Monetary Fund (IMF), of the task of obligating debtor countries to undertake fundamental financial and economic-policy reforms. Convincing steps in this respect would, moreover, facilitate negotiations between debtor countries and creditors.

6. Interim solutions required
There is no evidence so far of potential price effects (higher interest rate on newly issued bonds) due to CACs. In addition, bond restructuring involving the bulk of creditors has been carried out in the past also without CACs. If bond creditors realise this, the difference in price between bonds with and without CACs is unlikely to become serious. Nevertheless, the introduction of CACs may also raise problems. Depending on the market environment, price differences cannot be completely ruled out. Moreover, CACs can only apply to new bonds, so that a distinction will be made between bonds with and without CACs during a transitional period.

Without a significant and sustainable improvement in the general assessment of long-term debt sustainability, the inclusion of CACs in the terms and conditions of bonds issued by heavily indebted eurozone countries is therefore likely to encounter acceptance problems among investors and trigger significant risk premiums. New bonds with CACs would effectively be made junior to existing debt. Given the only gradually growing volume of new bonds with CACs (and the still high volume of existing bonds), such “junior bonds” could be seen by investors as extremely risky.

Solutions must therefore be found to allow the smooth introduction of CACs also in countries where there would be no acceptance of such new bonds at present. The following options are conceivable:

1. Further conditional EU structural aid to improve the medium-term debt servicing capacity of the country concerned. 
2. Arrangements for new issues that initially limit the loss participation of the new bonds to a certain amount that is gradually increased over time;

The Principles for Stable Capital Flows and Fair Debt Restructuring drafted by the Institute of International Finance (IIF) in collaboration with representatives of emerging-market countries provide a sound basis for orderly debt restructuring negotiations with and without CACs.

7. Seniority of ESM loans may delay return to capital markets
The proposed seniority of EMS loans (junior only to IMF loans) should be reviewed critically. The junior ranking of private claims could lead to a risk premium on the capital market rate for the country concerned if the support measures and reform programmes do not bring about any fundamental improvement in its debt sustainability. It should also not be overlooked that the junior ranking of bonds also influences bond ratings and may therefore make them unattractive for certain investors from the outset or lead to incompatibility with investment rules. Moreover, there is the danger that the graded ranking (IMF loans ® ESM loans ® private creditor loans) and thus stronger differentiation of creditors will increase complexity and reduce liquidity in the relevant market segment. Here, too, it should be borne in mind that any unnecessary fragmentation of asset classes would result in less market liquidity and could impair the functioning of the secondary markets.

8. Restructuring of existing debt only on a voluntary basis
Should, despite best efforts, restructuring of a eurozone country’s debt be unavoidable, the following points are particularly important:

• For creditors, restructuring can and should be carried out only on a voluntary basis. Depending on the circumstances of an individual case, a sufficient number of investors could well participate in restructuring. Past experience shows that whenever debtor countries negotiated with their creditors on a goodwill basis, the non-cooperative investors (also without CACs) remained a small minority and were unable to prevent successful restructuring.
• Upon participation of private creditors before 2013, the date envisaged for introduction of the EMS, the relatively large exposure of institutional investors – i.e. banks, but also insurance companies and pension funds – in eurozone sovereign bonds may cause problems. Thought should therefore be given to additional instruments to prevent such creditors from being overburdened. This raises the question of which measures could be adopted to allow these creditors to shoulder the burden of restructuring without impairing their important macroeconomic functions. A repurchase programme (see 3.) could facilitate voluntary negotiations.
• Restructuring should be an exceptional event. Successful restructuring should not be seen by other countries as the most convenient way of getting rid of their sovereign debt.  At the same time, investor fears of restructuring being applied to other countries could increase. To limit this danger, it would be helpful if restructuring is only carried out where troubled countries record primary budget surpluses (budget balance excluding interest payments).
• There should be no preferential treatment of certain groups of investors in any restructuring. Every bondholder must have the same rights. That goes particularly for the conceivable attempt to place the burden of restructuring solely on direct creditors. The orderly settlement of securities repurchase, securities lending and loan hedging transactions (including CDSs) should remain fully possible where restructuring takes place and agreements should remain valid (respect for capital structure). Any deviation from this key principle would invalidate current assumptions about the probability of sovereign bond default and unsettle the markets accordingly. The notion that chain reactions can be avoided by prohibiting the use of hedges would be a fatal fallacy. In fact, banning such hedges would have unforeseeable consequences and sharply increase general uncertainty.