The upward trend in government borrowing occurring over decades has become noticeably acute with the far-reaching economic crisis of the last few years, particularly in advanced countries. This deterioration has become so intense that it raises questions regarding whether some of these governments have reached or are on the way to reaching unsustainable levels. Unfortunately, the euro area's atypical institutional framework has pushed some countries in this region to the top of the list of suspects. By way of consolation, one positive aspect is the existence of useful mechanisms to handle the debt crisis, at least with a view to avoiding scenarios of disorderly default. But these need to be used wisely.

Before considering the particular features of the euro area, it is useful to review the international initiatives employed to instil an overall regime of prevention and resolution for the sovereign debt crisis. Progress has admittedly been slow, although recently it has appeared to speed up to some extent. At a government level, for years the G-20 has been promoting the establishment of protocols of action and forums for negotiation and decision-making in episodes of crisis. In the private sector, the Institute for International Finance has also shown itself to be highly active in this respect. But perhaps the most significant reference is the Sovereign Debt Restructuring Mechanism (SDRM) endorsed by the IMF. Initially these initiatives were proposed for emerging countries in response to their traumatic experience due to the long series of external debt crises during the 1980s and 1990s. The distinction between internal and external debt is important in both a theoretical and empirical analysis of sovereign default. The decision to default entails aspects of capacity («being able») and will («willingness»), depending on the alternative measures available, such as fiscal adjustment, selling off assets or debt monetisation. In this last option, internal default is more closely related to will and external default to capacity. In the area of prevention, the main elements promoted are those aimed at encouraging market discipline (governments providing reliable information, appropriate incentives from rating agencies, etc.), as well as surveillance and advice provided by supranational bodies. When it becomes necessary to tackle resolution, the proposition is similar to that of national legislation in the area of bankruptcy: reducing the debt burden to sustainable levels that can be effectively dealt with, at the lowest possible cost for all the parties concerned. Three kinds of cost stand out. First of all, obviously, creditors suffering from losses due to default. Second, the damage caused to the reputation of the defaulting country (and its policies). Third, the risk of contagion and systemic impact. The importance of these variables explains why it is useful to have a procedure that helps to restructure public debt in an orderly and negotiated mode, far away from repudiation formulae. The IMF has become involved by presenting, in 2013, a proposal to reformulate the SDRM.(1) The proposed design contains some very interesting elements. The SDRM is activated only at the request of an IMF member who must justify that the debt to be restructured is unsustainable. A representative creditors' committee is then formed that is responsible for addressing both debtor-creditor and intercreditor issues. The debtor would bear the costs associated with the committee. But the ace up the sleeve of the SDRM is «creditor aggregation»: if a qualified majority is achieved (75%), any decisions reached will apply to all creditors. This stops small groups (such as «vulture funds») from being able to refuse to join the operation and block it for their own ends. Another legal provision with similar effects consists of «collective action clauses» (CACs), although these only apply to specific financial instruments (bonds whose prospectus or other governing rules contain CACs) so that, in order to approve the restructuring of debt containing CACs, this operation must be carried out bond by bond. The SDRM covers the resolution of possible conflicts through an independent forum. Specifically, the Managing Director of the IMF appoints a panel of judges who, in turn, are responsible for choosing those professionals who will ultimately make up the forum.

Within the euro area, the authority from each country cannot use monetary policy as a tool to tackle debt crises given that this role is assigned to an independent institution: the European Central Bank (ECB). Moreover, the ECB statute explicitly forbids it from financing Member states, at the same time as the lack of a centralised treasury leaves it without any fiscal support. To a certain extent, this means that governments' debts are as if they were all in foreign currency, placing them in a more vulnerable condition. And to top it all, the Maastricht Treaty specifies a «no bail-out clause» by which Member states are not responsible for nor can they take over the commitments or debts of the other members. However, the Treaty does not state what should be done should a country with problems require assistance. Almost twenty years after the Maastricht Treaty was signed, Greece's long, tortuous crisis has highlighted the need for a specific institutional framework that helps to resolve the sovereign debt crisis. Simplifying for the purposes of explanation, and adopting the jargon created over these years, the options available to a euro area country when it is unable to meet its debt payments can be grouped into two categories depending on who bears the burden. On the one hand, «Private Sector Involvement» (PSI) measures, which basically involve some kind of debt restructuring: lowering interest rates, extending repayment periods and even haircuts. On the other hand, «Official Sector Involvement» (OSI) formulas; i.e. the aid provided by other states or international bodies (IMF, etc.), which can take a wide variety of forms: at present forced to get around the no bail-out clause but with proposals aimed at mutualisation.

Regarding PSI, the key element is the expediency or even the necessity to secure the «approval» of bondholders, which can often become an insurmountable obstacle. The Greek case, initially seen as a voluntary exchange of bonds, turned into a real drama: turbulent negotiations and delays culminating in a controversial backdated application of CACs by the Greek government. The European authorities have since taken note of these dysfunctions. The main measure has been the agreement for all government bonds issued in the euro area to include CACs, ex ante and with standardised terms, as from 1 January 2013. But it would also be useful to improve the institutional framework and the protocol for the negotiation process, detailing criteria and those responsible for deciding the terms of a reasonable, fair restructuring. One interesting proposal in this respect(2) is the European Crisis Resolution Mechanism (ECRM) which would be based on the following principles: it would only be activated on evidence that the debt situation was unsustainable; it would not interfere in the sovereignty of the debtor country; it would provide incentives for the debtor and creditors to negotiate; it would mean that, should the debtor and a qualified majority of the creditors reach an agreement, this would be binding for everyone and the integrity of this process would be safeguarded by an impartial, efficient dispute resolution system. The proposed ECRM would consist of three separate blocks. A legal body with the authority to start proceedings upon the request by a euro area government. An economic body to assess whether the government's debt in question is unsustainable and the terms for a reasonable agreement. And a financial body capable of providing financial assistance in the short and medium term to help the debtor country make the necessary adjustments. This last body entails the incorporation of a component of official aid (OSI).

For the time being, OSI has taken the form of loans (initially bilateral between governments with the participation of the IMF and then channelled via the EFSF and the ESM). Nonetheless, there have been complaints that the no bail-out clause has been violated, claiming that the loan conditions conceal a subsidy, or warning that lenders were taking on risks. Mechanisms openly aimed at the mutualisation of liabilities and risks (such as Euro bonds) do not seem viable at the current stage in the process of European integration. However, Intermediate formulas are being considered that might be of great use given the challenge of debt sustainability in some countries. One singular proposal, given its origin (the German government's Council of Economic Experts) and its promoters (the European Parliament and Commission) is the so-called European Redemption Fund (ERF), designed as an equilibrium between two fundamental principles.(3) The first is «accountability»: an irrevocable commitment of all countries in the area of fiscal discipline. The second is «solidarity»: those countries going through problems will be supported by the rest. The ERF's main idea is to separate all the debt accumulated by a Member state into two parts. The first part is equivalent to 60% of its GDP, the limit contained in the Stability and Growth Pact. The second consists of all the debt above this threshold. This second part could be transferred to the ERF, where all members of the euro area would have joint accountability. At the same time, each country must guarantee the debt transferred with a deposit in the form of international reserves, which would be forfeited should it fail to honour its commitments: namely to maintain the non-transferred debt below 60% of GDP, keep the budget deficit below 0.5% of GDP, incorporate «debt brakes» at a constitutional level and eliminate the debt transferred within 25 years. The desired effect of this mechanism is to reduce the cost of financing countries in difficulty, thereby improving the sustainability of their overall debt.(4)

Undoubtedly striking the right balance between PSI and OSI represents one of the Gordian knots in the current process of crisis and the re-establishment of the euro. Its beginnings in 2009 were not very promising but, little by little, it seems as if the different agents involved are getting on track, although there is still a long way to go.

Financial Markets Unit
Research Department, "la Caixa"