A Mechanism to Regulate Sovereign Debt Restructuring in the Euro Area. J. Andritzky, D. I. Christofzik, L. P. Feld, U. Scheuering.

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1 A to Regulate Sovereign Debt Restructuring in the Euro Area J. Andritzky, D. I. Christofzik, L. P. Feld, U. Scheuering Lars P. Feld Member Jochen Andritzky Secretary General SVR_Wirtschaft jandritzky July 216 GCEE proposal Maastricht 2. : Necessary elements for a stable framework that retains national fiscal sovereignty. A solid framework for the Euro area: Maastricht 2. Fiscal and economic policy No-bailout clause Strengthening of the market discipline Reformed Stability and Growth Pact Preventive and corrective arm Fiscal compact National debt brakes Crisis mechanism European Stability (ESM) Sovereign insolvency mechanism Linkages: Financial support in case of sovereign insolvency Ex-ante conditional liquidity support(compliance with Stability and Growth Pact) Financial back-upfor bank restructuring Financial framework European banking union Supervision Restructuring and resolution Restructuring fund But: national deposit guarantee schemes Accompanying measure: Phase-out of regulatory privileges for sovereign bonds National responsibility European responsibility Sachverständigenrat SVR

2 GCEE proposal Bail-in Maastricht invoked as part2. of ESM : programmes Necessary elements for a stable framework Enhance that ESM retains fire power national fiscal sovereignty. A solid framework for the Euro Protect area: Maastricht ESM funds 2. Fiscal and economic policy Crisis mechanism Financial framework No-bailout clause Strengthening of the market discipline Reformed Stability and Growth Pact Preventive and corrective arm Fiscal compact National debt brakes European Stability (ESM) Creditor Sovereign Participation insolvency mechanism Clauses Linkages: Financial support in case of sovereign insolvency Ex-ante conditional liquidity support(compliance with Stability and Growth Pact) Financial back-upfor bank restructuring Anchor market expectations National responsibility Avoid legal tussles European banking union Supervision Restructuring and resolution Restructuring fund But: national deposit guarantee schemes Reduce dead weight loss from restructuring Share burden more evenly Accompanying measure: Phase-out of regulatory privileges for sovereign bonds European responsibility Sachverständigenrat SVR Example: Euro area Troika programmes 142 billion for debt repayments as per initial programme projection 62 (Greece), 21 (Ireland), and 64 % (Portugal) of total funding needs 1 Financing needs during the crises in Greece, Ireland and Portugal Greece Euro billion 5 Ireland Euro billion 5 Portugal Euro billion a b c d b General governmentdeficit 2 Long-termdebtsecurities 1 Sum of generalgovernment deficitandamortisation of long-term debt securities. 2 Greece: including PE borrowing need. a May-December. b January -June. c IncludingDecember 21. d June-December. Sources: EuropeanCommissionandowncalculations Sachverständigenrat SVR

3 Existing proposals (selection) Proposal Year Authors Setting triggers What aspects does the proposal address? Calibrating debt relief Preventing holdouts Facilitate transition European Debt Restructuring European Crisis Resolution (ECRM) European Monetary Fund (EMF) European Stability 21 Weder di Mauro, Zettelmeyer ESM, 2 hard thresholds 21 Gianviti, Krueger, Pisany-Ferry, Sapri, von Hagen 21 Gros, Mayer EMF Guarantee <6% GDP 211 Corsetti, Devereux, Hassler, Saint- Paul, Sinn, Sturm, Vives Court decides Court decides New debt ESM, soft 3- stage Market prices Trigger clauses 211 Weber, Ulbrich, Wendorff ESM 3-year extension European Sovereign Debt Restructuring Viable Insolvency Procedure for Sovereigns MEZ proposal 213 Buchheit, Gelpern, Gulati, Panizza, Weder di Mauro, Zettelmeyer ESM, hard threshold CACs Bond clause Immunity clause 214 Fuest, Heinemann, Schroeder ESM, soft CACs + immunity 215 Corsetti, Feld, Lane, Reichlin, Rey, Vayanos, Weder di Mauro ESM, hard thresholds Redemption fund Wait until 23 Debt buyback Source: Authors. 5 Time line Programme request ESM Programme with strict conditionality Debt sustainability analysis by ESM First stage debt operation Eligibledebt 1>6-9%GDPor 1 Eligible debt funding requirement > 15-2% GDP or >2-3violationsoffiscalrulesinlast5years Maturity extension for duration of programme Second stage debt operation if necessary Based on debt sustainability analysis by ESM Completed before programme end Deeper debt restructuring 1 Newly issued debt including Creditor Participation Clauses. Source: Authors time Sachverständigenrat c 6 3

4 Implementation Principle of private sector involvement already in place Preamble (12), ESM Treaty: In accordance with IMF practice, in exceptional cases an adequate and proportionate form of private sector involvement shall be considered. Mirroring IMF new lending framework agreed by 189 member countries Legal/regulatory foundation New class of bonds with single-limb voting CACs Enforcement moratorium to be anchored in ESM Treaty Also: retain possibility to restructure old debt and limit coupon payments Also: phase out privileges for sovereign exposures in banking regulations Also: keep ECB liquidity window open to bonds with maturity extension 7 Phase-in (1) Transition: phase-in through introduction of new clauses Applies only to sovereign bonds issued by central governments Maturinglongtermsovereignbonds 1 12 %ofgdp year Belgium France Germany Ireland Italy Portugal Spain 1 Sampleoflongtermsovereignbondsissuedbycentralgovernmentssince1999asofend-214.Figureforyear23includesall amountsmaturingin23orlaterin%of23gdp. Source: Eidam(216) Sachverständigenrat SVR

5 Phase-in (2) PenetrationofdebtstockwithbondsincludingCreditorParticipationClauses(CPCs)issuedfrom217 1 % year Belgium France Germany Ireland Italy Portugal Spain Deficitsanddebtrefinancedwithnewclassofbonds 2 Deficitsrefinancedwithnewclassofbonds 3 1 Assumesbondsareissuedwithnewclausesstartingin217basedonmaturityprofileforbondsasofend-214,with(i)maturityof newly issued bonds similar to 214 and(ii) nominal debt following European Commission(215) and extrapolated from Assumes that shares of other debt relative to GDP remain constant. 3 Deficits until 226 based on European Commission(215), and converging towards.5% of GDP at a speed of.5 percentage points afterwards. Bonds with CPCs falling due are rolled into similar bonds. Source: Eidam(216) Sachverständigenrat 16-73_W 9 Who shares the burden? Holdersofadvancedeconomygovernmentdebts,215Q2 1 % 1 % Belgium France Germany Ireland Italy Portugal Spain Domesticbank Domesticcentralbank Domesticnonbank ForeignprivateEA SMP ForeignprivatenonEA Foreignofficialsector(excludingSMP) Totaldebtin%GDP(righthandscale) 1 FractionsofEA-holdingsfromlastavailableyear, mostcountriesend-214; Belgium, Italy, Portugal, Spain: fromend-213. SMP-holdings arecalculatedusingthetotalreportedvaluesat3july215andthebreakdownbyissueroftheoutstandingamountsoftheeurosystem's SMP-holdingsasofend-214. Sources:ArslanalpundTsuda(212),ECB,CPISDatabase,andowncalculations Sachverständigenrat SVR Mostly intra-euro holdings differ from EM restructurings, but: Too big to be saved issue (e.g., Italy?) Reduce uncertainty (-> indirect spillovers) 1 5

6 What are the risks of spillovers? InterestratespreadsongovernmentbondscomparedtoGermany 1 basis points 1,6 1,4 1,2 1, France Ireland Italy Portugal Spain 1 Differences between the yield on 1-year government bonds of each country relative to German government bonds. Source: ThomsonFinancial Datastream Sachverständigenrat SVR Serious valuation effects even absent restructuring mechanism 11 How serious are losses in the long run? Long-term investors can benefit from upside following crisis resolution Longtermreturnsofsovereignbondsduringdebtcrises Frequency distributionof sovereignbond returns by typeof crisisresolution Frequencyin% Returns of sovereign bonds undergoing restructuring Totalreturnin% Argentina Russia Ecuador Belize Grenada Uruguay Ukraine Dominican Republic Pakistan to to to to to to to to Annualisedexcessreturnin% LossinNetPresentValuein% 2 Haircut Maturity extension Norestructuring Haircut Maturityextension 1 Returnsduringa timewindowstarting2 trading daysprior to crisisandending 2days aftercrisis end. Sample countriesincludeargentina(1998, 21 25, 28), Belize(26, 288, 211), Brazil(1998, 22), Bulgaria(1998), Colombia(1998, 22), DominicanRepublic (23 25), Ecuador(1998), Gabon(28), Ghana(28), Grenada(24), Iraq(28), Jamaica(28), Lebanon(21), Nigeria(1998), Pakistan(1998, 28), Russia(1998 2), Serbia(28), Seychelles(28), Sri Lanka(28), Turkey(21), Ukraine(1998, 28), Uruguay(22), Venezuela(1998), andvietnam(28). 2 According totrebeschandcruces(213). Source:AndritzkyandSchumacher(forthcoming) Sachverständigenrat

7 Complementary measures and questions for clear rules of the game, augmented by Phase out regulatory privileges (home bias may be endogenous) Promote creation of buffers, e.g. insurance sector? Apply stress test and crisis simulations Does the mechanism deter requests for ESM assistance? More room for gradual fiscal adjustment and longer programmes ESM programme needs to take spillovers into account No decision on deeper restructuring needed at ESM programme inception What about fiscal discretion and funding costs? No Trojan horse to restrain fiscal policy, national responsibility for fiscal policy Scarce evidence for general increase in funding cost or market volatility 13 Thank you! 14 7