This paper endeavours to offer a view on the need of an orderly sovereign default process in the EU. Paragraph 1 provides an introduction. Paragraph 2 illustrates why, a Greek or other peripheral EMU country default would not trigger a systematically relevant banking crisis which could entail the need of additional (substantial) state aids. Paragraph 3 briefly comments on the indirect, but relevant, costs associated with a sovereign default in the EMU area. Paragraph 4 considers the May 2010 sovereigns’rescue package and whether it is compatible with an orderly default procedure. Paragraph 5 calls for the swift introduction of a European statutory sovereign default procedure also to reconcile properly the May 2010 initiatives with their legal basis. Paragraph 6 lists a series of statutory provisions which should be incorporated into the European sovereign default procedure. Paragraph 7 concludes, briefly commenting on the idea of a European Monetary Fund and its legal basis under the current TFEU.

SOMMARIO:

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1.

History shows that big financial crises are often followed by sovereign defaults. Thus, there is very little new in the feared (and threatened) Greek default in this respect; what is new is however that: (i) this would have been the first sovereign default of a western European country since the interwar period and, obviously, the very first of a EMU member (entailing yet unknown implications for the common currency); (ii) the Greek default could potentially inoculate contagion to other EMU members (notably Portugal, Ireland and Spain, and, to a lesser extent, Italy), leveraging the risk of a currency crisis; (iii) the magnitude of the economic resources devoted by the EMU members and the IMF to avert (or at least tame) the risk of default through official sector intervention is unprecedented. Suffice to say that the rescue package adopted in May 2010 totals more than one trillion USD in loans available for countries with funding problems: an amount significantly above that committed by the US under the TARP in 2009 [1].

2.

Sovereign defaults are historically related to banking crises; often in the sense that sovereign defaults weaken the banks’balance sheets and, in the extreme, could even create the threat of a bank run. In the current financial crisis the circle has been perhaps even more vicious [2]. Indeed, the financial crisis and, to some extent even banks’rescue packages adopted in 2008-2009 (the case of Ireland seems to be quite illustrative in this respect), contributed significantly to the worsening of the debt to GDP ratio of many sovereigns bringing about the risk of a sovereign crisis [3]. However, in the current scenario a risk of contagion from EMU peripheral sovereigns back to the European private banking sector should not be overestimated either. The Greek example seems quite exemplary. Greek outstanding national debt is reported to be around € 300 billion, roughly equivalent to about 125% of the country GDP. The country’s budget deficit is estimated at about 12.7% of the GDP. The Italian, German and French banking system exposures to Greek sovereign debt calculated at the end of the third quarter of 2007 and at the end of 2009 were as follows:   Lenders’country Exposure in 2007 Exposure in 2009 Italy 06,3 04,8 France 41,3 52,2 Germany 25,6 31,2         Note: Data expressed in € billion. Source: Bank of Italy (briefing note of the hearing of Dr. Fabio Panetta at the Italian Parliament, Rome, 8 June 2010).   This finding is plainly confirmed by the recently published (23 July 2010) banks’stress test performed by the ECB, which contemplates haircuts on sovereign debt but does not consider sovereign default in the exercise [4]. The same holds true, according to a different (albeit less sophisticated) stress test performed by a leading investment bank, also in a worst case scenario, where the severity of the test contemplates several sovereign defaults of peripheral EMU countries occurring at the same time and an haircut of 30% of the face value of the sovereign bonds. Indeed, a Bank of America/Merrill Lynch Report of 10 May 2010 (“Sovereign fears: direct impact manageable”) shows, albeit with several cautionary warnings (in very few cases there were available the exposure to peripheral European sovereign debt, and not all banks had disclosed their [continua ..]

3.

This is not to say a sovereign default of a EMU member would be without significant impacts on the global financial system of the area. Although direct effects of a sovereign default on banks’balance sheets could prove manageable, its indirect effects could have a negative longer term impact both on funding and economic growth. The impact on funding could, on one hand, derail the bank funding recovery still underway and, on the other hand, make funding costs higher and more differentiated within the Euro area on country-specific fundamentals. On the other hand, as it has been recently observed by Hui and Chung [6] “the onset of the European sovereign debt crisis in late 2009 called into question the grand experiment of pooling 16 countries into a monetary union”. It results indeed that “sovereign credit risk is an important determinant of the prices of deep out-of-the money dollar-euro put options” and that, therefore, “the creditworthiness of the euro-area countries could affect market expectations on the stability of the euro”. In other terms “the atmosphere of collective safety provided by a common currency in the first 10 years of its existence is gone (probably for good)” [7]. This is due to the fear of a chain reaction; and such a chain reaction was considered as a real possibility by the market, since currency traders and hedge funds reportedly betted nearly USD 8 billion against the euro, amassing the biggest ever short position since the monetary union was formed [8]. The weakness of the euro signals also the deep deterioration of the debt to GDP ratio of all EU members: rating agencies expect that by the end of 2010 sovereign debts in the EU area will increase of 760 billion in respect to end 2009; of these, 490 billion concern EMU countries: an amount six times bigger than the increase experienced in 2007 [9]. As Willem Buiter, Citi’s chief economist wrote in a recent note [10] (i) “the public finances of advanced industrial countries are in a worse state today than at any time since the industrial revolution, except for wartime episodes and their immediate aftermath”; (ii) “most of the industrialized nations are on unsustainable fiscal trajectories”; (iii) “fiscal unsustainability problems have been driven by (1) pro cyclical fiscal behavior in the boom years; (2) direct fiscal costs of the financial [continua ..]

4.

All the foregoing – probably coupled also with a strong, albeit undemonstrated, official belief (transmitted also to the market) that the Eurozone cannot endure a single sovereign default among its members [11]– should help in understanding the reasons beneath the adoption: a) on May 3, 2010, of the 2010-2012 program of financial support for Greece up to 110 billion, 80 of which extended as bilateral loans by other EMU members; note that in some cases the financial effort required by a single EMU member is quite disproportionate in respect to the threat posed by the Greek sovereign debt held by its national banking system (Italy, for example, made available through Decree no. 67 of 10 May 2010 up to 14,8 billion Euro, an amount three times higher than the exposure of its banking system to the Greek sovereign risk); the same day the ECB – in order to prevent disruptions on the side of liquidity, especially for the Greek banks, derogated to the rating requirements for the Greek sovereign bonds used as collateral in liquidity transactions; b) on May 10, 2010 of the European Financial Stability Facility, through which EMU Members, in a final attempt to prevent sovereign defaults in the EMU and the correlated risk of contagion, decided to put at stake (although indirectly: enabling the Facility to extend conditional loans to EMU members facing exceptional circumstances up to 500 billion and undertaking, at the same time, to guarantee the euro bonds to be issued by the Facility to fund such loans) an unprecedented amount of their taxpayers’money; the same day the ECB adopted the Securities Market Program to support failing euro denominated government bonds in order to prevent new disruptions in such markets; c) on May 12, 2010 of the joint Communication on “Reinforcing Economic Policy Coordination” (COM 2010 250 final). In turn, the foregoing should also help in making clear that, despite all these efforts and programs, one or more EMU members could eventually end up confronted not simply with a liquidity crisis – which can be overcome through the extension of the loans made possible by the newly adopted European programs – but with a true solvency crisis. This means, to my mind, that an orderly default procedure could eventually follow the European Financial Stabilization Mechanism and Facility and should be considered compatible with it. For Greece, an insolvency scenario has been recently [continua ..]

5.

In this context it is worth questioning: (a) whether it makes sense that the EMU does not provide any orderly European sovereign default procedure and what form this procedure could take; (b) whether there is sufficient legal basis in the Treaty for the measures adopted on 9 May 2010 setting up the European Financial Stabilization Mechanism and Facility and for the adoption of an orderly European sovereign default procedure. On this latter point, it is well known that all the measures adopted in the last months to face the feared sovereign default must be assessed against the so called “no bail out” provision of Article 125 TFEU, taking into account, though, also the enabling provision of Article 122 TFEU which entitles the Council, on a proposal from the Commission, to “grant under certain conditions Union financial assistance” to a Member State where it is “in difficulties or is seriously threatened with severe difficulties caused by (…) exceptional circumstances beyond its control”. It is apparent that European institutions stretched quite a bit the enabling provision of Article 122 and at the same time construed in a very restrictive way the “no bail out” provision of Article 125 to find a sufficient legal basis in the Treaty for the measures recently adopted. The underlying idea was that the extension of conditional loans does not amount to the “assumption of the commitments of central governments” (as prohibited by Article 125 of the Treaty) and that the current sovereign difficulties, albeit deriving from lax fiscal and budgetary policies of the Member States concerned, could nonetheless be characterized – in consideration of the extraordinary effects derived from the on going global financial crisis and, to be true, using also a discreet amount of hypocrisy – as “exceptional circumstances beyond the control” of the Member State concerned. The impression is very strong, however, that EMU countries, having failed to prepare in advance a mechanism capable of managing an orderly default and debt restructuring within the EMU, acted to prevent any sovereign failure in the strong belief that such a failure could be too dangerous for the EMU. Watering down the “no bail out” provision (as well as Article 123 TFEU) could prove very dangerous also. It does not come as a surprise, thus, that markets reacted negatively on the currency, “fearing that [continua ..]

6.

How then to devise a proper European or EMU default procedure? Reliance can be made both on international experience and on some recent proposal calling for the setting up of a European Monetary Fund. As to the former point, in my view there is here a very strong case for a European statutory procedure based on a EU regulation (under the existing TFEU), which should set out in detail mandatory rules aimed at making the restructuring process more orderly, more predictable and more rapid. The reasons that supported the attempt to introduce such a process in the international setting [16] – an exercise which failed so far, despite the IMF 2002 proposals and the authoritative support that this project received by leading scholars [17] – are even more compelling within the EMU [18]. In my opinion, pure contractual solutions do not adequately respond to European needs. As to the form that an orderly default procedure should take, the economic literature indicates that statutory provisions should comprise at least the following (the list is purely indicative and in no way comprehensive): a) a timely suspension on re-payment to prevent a rush to exit from the sovereign debt, applicable once the default is declared; default should be made possible both on a voluntary basis (i.e. the sovereign declares the default starting the procedure) and on a involuntary basis (i.e. the creditors call the default, starting the procedure), since the economic literature convincingly demonstrated that involuntary bankruptcy would alleviate the sovereign’s reputational concerns in calling for a more timely voluntary procedure and would also provide a mechanism for creditors to block new debt issues which could dilute their outstanding claims[19]; b) a “fair” priority rule, according to which creditors should be divided into different classes with different rights depending on a set of criteria preemptively defined. To my mind, “first-in-time absolute priority” – i.e. the principle whereby bonds issued first would have priority over those issued later and higher priority creditors would be paid up in full before lower priority creditors receive anything – might prove too harsh and may even lack fairness[20]; a differentiation in the amount of the haircut depending on the time of the issue, the type of collateral and other relevant circumstances (if any) could prove a more viable and [continua ..]

7.

 Is there merit, in the current circumstances, for a further advance of the regulatory framework, so as to set up, as advocated by some commentators, a European Monetary Fund [27]? To my mind, probably there is. But only through the enhanced cooperation procedure: a procedure which, so far, has never been followed. And not surprisingly so.

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