Sunday, June 13, 2010
Europe Needs A Sovereign Bankruptcy Procedure
By Hans-Bernd Schäfer
The bailout for Greece has spoiled the reputation of Chancellor Angela Merkel so much, that almost nobody in Germany wants her in charge when the next crisis unfolds. First she was not far sighted enough to see the upcoming danger and when the danger was clear and present she was not courageous enough to fight for the right decisions. First she subordinated the problem to internal affairs like a provincial election and insisted that this is only a problem between Greece and its creditors. Later she was overrun by coordinated efforts of banks and other creditors to grant a complete bailout.
What went wrong? The fathers and mothers of the EURO simply ruled out the possibility that a member of the Euro-Zone might default. Had they studied financial history they would have known that sovereign bankruptcies are in the long run as numerous as snowflakes. The Greek crisis would have been swiftly solved without any impact on the credibility of the Euro, had a sovereign bankruptcy procedure been in place, as it already exists for cities in the United States. When in the USA a large city goes bankrupt that does not even cause headlines around the world, let alone affects the strength of the dollar. Greece however, with an economic weight of 2.6% of the Euro area’s GNP could send the Euro into decline, because no orderly procedure existed to deal with the crisis.
A well-ordered method for sovereign bankruptcy should observe in particular the following four objectives, including the appropriate legal instruments. First of all, after the government of the debtor nation has declared sovereign bankruptcy, the creditors – just as with normal insolvency proceedings – should remain inactive to generally prevent the draining off of foreign currencies. This limits the effects of the crisis on the real economy. Secondly: the proceedings should create incentives for the debtors and creditors to keep from carelessly or even thoughtlessly increasing the foreign debt. These proceedings also allow outsiders to impose harsh terms and reforms on all offers of help to the nation whose debt is to be restructured. It includes prescribing a haircut for creditors by reducing interest payments or writing off a part of the debt and reduce it to a sustainable level. When this occurs, the insolvency proceedings cast a long shadow on the behavior of the creditors and debtors at the time the loan was given. It leads to ex ante efficiency of insolvency proceedings. Thirdly, the conditions of the economic policy in the debtor nation should ensure minimum standards for the maintenance of essential public services. Fourthly, an independent person or committee, who neither follows personal interests nor is dependent on the interests of third parties and is in the position to weigh the interests of all parties and make reasonable judgments, should coordinate the proceedings, for instance a European or International sovereign insolvency court.
If well-regulated insolvency proceedings had been established, Greece would have declared sovereign bankruptcy when mature bonds could no longer be refinanced. Greece could have then submitted an application to open proceeding to restructure its debt at an institution created for just this purpose. The application would have lead to a moratorium that would have prevented a sudden reduction of Greek debt by seizing foreign assets and the following notorious hemorrhaging. In official proceedings the application would have then been examined to determine which sanctions could be imposed on the nation. The state would receive a bridging loan or other help. The loan could either come from the IMF, other European countries or state banks. The holders of government bonds as well as bank loans would be called to pay for and receive a so-called haircut. If such a haircut would have endangered certain banks, which are too big to fail, the governments could have come to rescue the banks but not the equity capital of their owners. These proceeding would not have endangered the stability of the Euro. In fact, it would show that a difficult financial crises can be surmounted by the use of a well-ordered and legally conceived proceeding. The rules of crisis management would stem the danger of future crises and not expand them.
In the absence of any legal framework the governments of the Eurozone agreed on a complete bailout, which gives the wrong incentives to creditors. For a period of three years all Greek loans, which become due are replaced with credits from governments of the Euro Zone. After 3 years one third of all Greek debts will be shifted to the taxpayers in the Euro Zone without any burden to the creditors themselves. This is a bailout, giving creditors even more incentives to careless lending and spending resources to receive government support. And this is not even the end of the story. Even though Greece can replace all its due capital payments with new loans from the bailout package, the European Central Bank has started to buy huge amounts of Greek government bonds.
At best the bailout package has bought three years of time. After 3 years the Greek debt will be higher than today, then about 150 per cent of the national product. The huge reforms within Greece will have disrupted the economy, as the public sector will shrink and it takes more than three years for the private sector to provide almost a million of new jobs. To send Greece back to the capital markets after 3 years will most probably not work. Latest then a debt restructuring including a sizable haircut for Greek’s debtors will be unavoidable. It is to be hoped that the governments of the Euro zone come to realize this and invest their time into drafting a debt restructuring procedure which works and does not lay the foundations of more crises in the future.