What do German calls for an orderly sovereign-default scheme mean in practice?

DESPITE its deserved reputation as a nation of thrift and fiscal discipline, Germany has a habit of making bond markets nervous. At a European Union summit last month Germany won agreement to rewrite EU treaties to allow for a permanent scheme to deal with stricken euro-zone borrowers—including, it hopes, a mechanism for an orderly sovereign default. At that summit Jean-Claude Trichet, the head of the European Central Bank, warned EU leaders that talk of debt restructuring was likely to unsettle bond markets and drive up the borrowing costs of troubled euro-zone countries. So it proved. The gaps between the ten-year bond yield of Germany and those of Greece, Portugal and Ireland jumped sharply this week.

The desire for an agreed set of procedures for a public-debt default is not new. In 2001 Argentina defaulted on its foreign debts after huge bail-outs that went wrong. That failure sparked a quest, led by the IMF, for international rules to govern sovereign-debt restructuring. Then, as now, it was hoped that making default less messy would prevent costly bail-outs that served only to rescue a few lucky private creditors. It would also strengthen bond-market discipline.

The hard part is designing a system that enables a speedy agreement from creditors on how big a loss they are prepared to accept. After more than a year of deliberation the IMF produced a blueprint for a sovereign-debt restructuring mechanism (SDRM), which would be written into the treaty that governs the fund’s operations. But the proposals failed to get enough support from the IMF’s membership. America was reluctant to cede any legal power to a supranational authority. For their part, some emerging-market members feared that the SDRM would make their access to credit more expensive because it appeared to make default more likely.

Yet unless default is a realistic threat, there is little incentive for markets to distinguish between the bonds of disciplined countries like Germany and lax ones like Greece. And in a forthcoming paper, Jeromin Zettelmeyer of the EBRD argues that an SDRM-type scheme has a better chance of survival in Europe, where the practice of ceding some national legal powers to a larger entity is long established (and where spillovers from one country’s troubles to others are large). The fallout from Greece has been a much bigger shock to the euro zone than Argentina’s default was to the IMF’s wider membership. This sense of acute crisis means radical measures have more chance of being adopted.

A first challenge is to be clear about just how “orderly” a default can reasonably be. Any default or restructuring implies a reduction in debt: creditors do not get all their money back (at least when they expected to). All creditors would be hit. A default could not, for instance, spare banks from trouble: they cannot be treated differently both for reasons of fairness and because to shield them from the full effects of a default would only encourage them to load up on risky bonds in the first place. One way to protect banks from the fallout, and to discourage them from holding iffy bonds, would be to force them to set aside more capital against the bonds of countries with larger-than-average debts.

The best that can be hoped for is a process that is predictable; that takes place as soon as it becomes obvious that the debt burden is unsustainable (to stop good money being thrown after bad); and that is not held up by small groups of creditors seeking to achieve better terms than most would settle for. Just as a drawn-out bankruptcy dissipates the value of a firm’s assets, a default in which a country faces legal battles with squabbling groups of creditors weakens its capacity to repay debt.

To meet these requirements, an ideal sovereign-default scheme would have three main features. First, it would require someone to judge that the debt position is unsustainable. Second, it would need a supranational institution, such as the IMF or the European Commission, to oversee creditors’ claims and co-ordinate agreement on a settlement. This institution would need legal tools to bind all creditors to a deal agreed upon by a qualified majority (say, 75%) of them and to protect the debtor from legal challenges while that settlement was negotiated. A third element would be a mechanism to allow fresh credit to keep the defaulting country running. These funds would be senior to existing debts to shield them from the restructuring.

Opening chapter

The trickiest part of all this is the decision to start proceedings. Defaults are damaging and costly: banks are crippled, governments fall, populations suffer and countries are frozen out of capital markets. Often a defaulting country suffers lost years of economic progress, says Robert Koenigsberger of Gramercy, an emerging-markets investment manager. Debt-ridden countries will seek to delay the inevitable; their rescuers frequently will, too. One way to avoid delay is for the IMF or the EU to promise not to bail out countries whose debts go beyond a specific threshold, forcing them to seek a restructuring. A rules-based approach would have the benefit of clarity. But if the bar is set too high it would temporarily reprieve countries that are going to end up broke anyway; if set too low, it could force sound sovereigns into bankruptcy. A form of “constrained discretion” might work best, if the criteria used to make the judgment are known by all.

One aspect of default that could not be set by a rule is the size of the “haircut”—ie, how big a loss creditors have to bear. That would need case-by-case negotiation. But deals have been struck in the past, suggesting there is usually a decent sense of what a country can afford. Debtors may wish to drive a hard bargain but that risks delaying a settlement. The desire to move on is what leads countries to strike a deal (Argentina is a big exception). Haircuts range widely but are typically between a third and a half of the value of debts. Hence this week’s jitters.