A proposal to reinforce the European Stability Mechanism through supplementary bond issuance terms
Prof Dr Axel A. Weber, Jens Ulbrich, Karsten Wendorff
(published in Frankfurter Allgemeine Zeitung , 3 March 2011)
Honouring the letter and spirit of the European Council’s decisions
Both E urope i n general and t he eur o ar ea i n pa rticular a re c urrently facing major c hallenges. The dwindling confidence in the public finances of some member states constitutes a substantial handicap
– which theoretically should have been prevented by the existing institutional framework. In addition to remedying the present problems, it is thus crucial to improve the ways and means of preventing future crises and – should they nonetheless occur – the ability to tackle them more effectively.
The bottom line for all problem solving, preventive measures and crisis resolution is, of course, the need for each member state to act responsibly. Clearly, there is no prospect at present of any seismic shift in the basic political and ec onomic policy structures of the EU and the euro area. For one thing the European Council recently expressed its opposition to any major transformation, and for another it is doubtful whether a regime change – to a federalist model, a pol itical union or a j oint liability structure, for example – would receive a democratic mandate in the member states themselves. The individual m ember countries will t herefore continue t o hav e national decision-making sovereignty over broad swathes of economic and fiscal policy. Yet there is still room under this arrangement to encourage responsible behav iour from al l par ties – ie bot h governments an d financial m arket players – through incentives that notably take account of the negative effects of pursuing an unsound fiscal policy on the rest of the euro area.
Against this backdrop, the European Council agreed a blueprint for a future economic policy framework last December. Crisis prevention mechanisms are to be stiffened by beefing up the Stability and
Growth Pact (SGP) and stepping up macro-surveillance with a view to avoiding macroeonomic imbalances that could threaten stability. This will complement measures designed to substantially improve the financial system’s resilience through more focused regulation and surveillance that have already been initiated. Key conditions for avoiding future crises are
1. to really toughen the SWP’s disciplinary effect on fiscal policy and not weaken it, for example, through political horse-trading.
2. to f ocus m acro-surveillance on pr oblem c ases and av oid t he dang er o f h ands-on c entral planning that substitutes political fine-tuning for market mechanisms, and
3. to make the financial sector far more shock-proof so that risks stemming from financial stress on the part of banks or sovereigns are less systemic and more easily manageable.
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On top of the safeguards listed above, the crisis has highlighted the need for a crisis resolution mechanism to be kept in reserve for contingencies in which the preventive measures prove insufficient. On the one hand, such a mechanism must provide an effective means of resolving crises. On the other, it must not eliminate ex ante
the incentives for individual member states to ensure that their fiscal policy is sound or for financial investors to carefully evaluate risks, nor should it introduce joint liability ex post
. In this context, the E uropean Council has dec ided t o c reate a E uropean S tability
Mechanism ( ESM), w hich will c ome i nto force i n 2013. This dec ision s ends out a c lear message whose main thrust can be wholeheartedly welcomed. In principle, the mechanism is to be structured along t he lines of t he existing European Financial Stability Fac ility ( EFSF). Financial assistance is permitted only as a l ast resort, in cases where the stability of the euro area is under threat, and will be gr anted on condition of a s trict fiscal and economic adjustment pr ogramme being adopted and implemented. Key dec isions c oncerning this i ntergovernmental m echanism must be taken una nimously. To strengthen the incentives for governments and private investors to act responsibly and to protect taxpayers in the countries providing assistance, ESM loans will be accorded preferred creditor status and w ill have interest rate spreads equivalent to those on the current EFSF loans (which are bas ed on the financial as sistance gr anted to G reece). As a general rule, assistance can be granted for l iquidity pr oblems onl y. Any s olvency pr oblems m ust be d ealt w ith bef orehand by t he creditors and the government in question through agreements facilitated by collective action clauses
(CACs) that are to be incorporated into the issuance terms for sovereign bonds.
However, a number of demands that are currently being made with regard to the ESM would significantly change the character of the Council’s fundamental decisions. These include calls for the ESM to purchase the government bonds of problem countries or for interest rate conditions to be eased significantly, as well as requests to waive the loans’ preferred creditor status or the obligation for important decisions to be taken unanimously by the countries providing assistance. If taken on board, such proposals would weaken incentives to pursue a sound fiscal policy and substantially undermine some of the foundations of monetary union, such as subsidiarity, individual responsibility of member states and private investors, and the no bail-out principle. They must, therefore, be rejected.
Trigger c lause ex tending m aturity of gove rnment bonds would ho nour l etter and spi rit of
Council decisions
When put ting t he E uropean C ouncil’s g uidelines i nto pr actice, the ob jective s hould, i nstead, be t o strengthen the European Stability Mechanism in line with the Council’s decisions, while safeguarding financial market stability. There is a simple solution to many of the problems currently under discussion that would be both easy to implement and highly effective. This consists in supplementing the issuance terms of all bonds newly issued by eur o-area governments to include not only the planned
CACs but also a standard trigger clause extending the bond’s maturity. Under this clause, the regular maturity (eg five/ten years) of each bond would be extended by three years (to a total of eight/thirteen years) if the ESM were to accept an appl ication for financial assistance from the country in question before expiry of the original date of maturity. For this extended maturity, the bond would continue to be s ubject to t he a greed t erms and c onditions. The pr oposed ex tension i s t hree y ears bec ause a large part of the reform and consolidation efforts which the country concerned would need t o undertake should have been carried out by the time this period has elapsed. Such a concrete trigger clause in the contractual issuance terms of government bonds would offer an array of important benefits.
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Improved financial market stability
First, the inclusion of a maturity extension clause would do more to enhance financial market stability than t he E SM without t his addi tional m easure. The E uropean C ouncil has ag reed t o ac cord E SM loans pr eferred c reditor status – analagous t o I MF c onditionality – to protect t he t axpayers of t he countries providing assistance. This should be non-negotiable, above all f or Germany as the likely main provider of assistance funding in the future. However, this status could have some undesirable implications for the des ired i nvolvement o f t he private s ector: t hus i nvestors i n s hort-term bo nds would get off largely risk-free, whereas investors in longer-term paper would be bai led into any unavoidable future restructuring. These investors would then have to bear heavier losses than if there had been no assistance programme; their claims would be subordinated to those of the IMF and the
ESM and, in the event of restructuring, they would have to take the entire haircut. The greater the share of preferred debt (which itself largely stems from the financing of maturing bonds), the larger the haircut. This could drive down the prices of longer-dated instruments, and the resulting need for write-downs and the likely response of investors could generate risks to financial stability. Secondary market purchases, which should also be rejected for additional reasons of principle, would exacerbate this problem even further.
By c ontrast, i ncorporating a m aturity-extending trigger c lause i nto the i ssuance t erms o f s overeign bonds would mean that, notwithstanding the length of the residual maturity, all holders of the bonds of the country in question would face a similar default risk. This would spread price risks across more shoulders and so make them easier to cope with. Moreover, such a trigger clause would ensure – in line with the European Council’s guidelines – that all financial investors continue to bear responsibility for their investment and that liability is not passed on to the taxpayer in the event of a crisis. Investors would also benefit from the imposition of a strict reform and consolidation programme on the country in question and the fact that the countries providing assistance would be f unding any further deficits arising during the transitional phase through ESM loans. This should substantially curtail the probability of default.
The explicit inclusion of a maturity clause in the issuance terms for government bonds would eliminate some major problems associated with moratoriums for which there are no ex ante
provisions. Thus if such a clause were triggered, this would not constitute a c redit event (default) on the part of the debtor, s ince t he p rocedure would ha ve been l aid down ex ante
in t he t erms and c onditions. This would eliminate the potential uncertainties resulting from legal ambiguities, which might, for example, harbour the risk of freerider behaviour on the part of individual creditors. In addition, in the event of an extension of maturities, both t he direct impact on C DS c ontracts and a utomatic r ating downgrades should remain limited – and hardly any d ifferent to what they would be if ESM loans were g ranted without any extension clause. Changeover problems associated with amending the conditionality of sovereign bonds in this way are also likely to be limited given that there are already firm plans to include CACs, which themselves constitute a fundamental change. The large volume of euro-area government bonds should make it possible to swiftly establish a market standard.
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Greater protection of taxpayers in countries providing assistance, sharp reduction in required fund volume
One key advantage for countries providing assistance is that the need for support within the framework of an as sistance programme would be dr amatically reduced; it is “only” the current deficits (interest payments and primary deficits) that would need t o be r efinanced. However, these are likely to make up a fairly small part of the overall funding requirement – for instance, more than two-thirds of the loans t o G reece are ear marked for r olling over m aturing bonds . The m aturity extension c lause would thus sharply reduce the volume required by the assistance fund.
The inclusion of a maturity extension clause in the i ssuance t erms o f government bonds has the added advantage that, in the event of ESM assistance being granted, it greatly alleviates the major difficulty of differentiating ex ante
between liquidity and s olvency problems. Should it become apparent only in the course of the first three years of the period of assistance that the problem is one of solvency and t hat restructuring is unavoidable, considerable risks will not have been c oncentrated on a much smaller group of private sector creditors or transferred to the taxpayers of the countries providing assistance in the meantime.
Better financing conditions for crisis-stricken countries undergoing transition
However, in the event of a c risis, the countries receiving assistance would also benefit from the maturity extension clause. Particularly if a country unexpectedly suffers financial distress through no fault of its own (and therefore previously had relatively favourable financing conditions), the interest payments on the extended bonds are, in fact, likely to be lower than under the assistance programme.
This w ould al low t he c ountry c oncerned t o c onsolidate m ore rapidly. In addi tion, t hese c ountries would have planning certainty with regard to interest payments for the duration of the extended maturity.
Improved market discipline but limited additional borrowing costs
Sovereign debtors may incur higher costs from investors factoring in the specific risk of a maturity extension w hen t hey pur chase g overnment bond s s ubject t o such c onditionality. With t he increasing likelihood of an appl ication for assistance from the ESM being made and g ranted during the regular maturity, the interest rate expected when the bonds are issued would come increasingly close to the interest rate of a bond w hich, from the outset, has a maturity of an extra three years. In other words, the upper bound of the interest rate spread when the bond with a trigger clause is issued is the additional interest that would have to be paid on bonds with a three-year longer maturity.
Countries with a good credit rating will barely notice any increase in their interest rates. Their interest payments could even be lower if the proposed bond conditionality has the effect of reducing the threat to financial stability posed by restructuring and thus also the likelihood of a transfer to overindebted countries, and if it helps to improve market discipline throughout the euro area, leading to more stability-oriented fiscal policies.
The interest rate spread would also remain limited for countries with a weaker credit rating. For instance, a decision of the European Council has already laid down a f uture shift in maturities towards
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medium and long-term debt. However, the rise in the yield curve is usually relatively flat in this maturity segment, meaning that a maturity extension is likely to carry a fairly benign premium. The varying interest rate spread in line with sovereign credit ratings can, moreover, also be viewed as a form of financial market discipline which helps to strengthen incentives for pursuing a sound fiscal policy.
Conclusion
The future European Stability Mechanism s hould be ac companied by t he c ompulsory addition of a trigger clause to the issuance terms of euro-area bonds stipulating that maturities will be automatically extended by three years in the event of assistance being granted by the ESM. The planned general overhaul of sovereign bond issuance conditionality to include CACs would be an i deal opportunity to incorporate an amendment of this nature, which is both legally possible and transparent. Furthermore, extending the maturity would not constitute a credit event with all of the associated negative consequences. This addition of a trigger clause would provide a solution to a large number of problems that are currently under discussion. Such an arrangement would have many advantages for countries providing assistance, for financial stability and f or countries receiving assistance. The letter and s pirit of the E uropean C ouncil's pol itical g uidelines would be dul y honour ed and t he r eformed E uropean framework w ould g ain a us eful t ool to s ustainably enhanc e t he s tability o f t he currency uni on and permanently safeguard it for the future.
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