Sovereign Debt Restructuring and Debt Mutualisation in the Euro Area

The euro area lacks a framework for sovereign debt restructuring and it lacks a common risk-free asset. Both issues are important in looking ahead to the prospect of any future crisis. Of the two, however, the creation of some kind of sovereign debt restructuring mechanism appears to attract the most political attention. This briefing note outlines the issues that would need to be addressed to bring greater stability to the euro area.

The challenge of creating an effective sovereign debt restructuring mechanism for Euro Area Member States is both generic and Europe-specific. The generic challenge is to create incentives for governments to act in a timely manner and for investors to negotiate on a cooperative basis. The Europe-specific challenge stems from the unique characteristics of the European project. European financial markets are more integrated across national boundaries than those found in other parts of the world. By implication, the interest rate risks, contagion risks, spill-over risks, and reputational risks are in many ways exaggerated both by the volume of cross-border investment and by the importance of that cross-border investment for the smooth functioning of the internal market.

The unique characteristics of the European constitutional arrangement are important as well. Euro Area Member State governments cannot be bailed out by their central banks, they should not have privileged relations with commercial financial institutions, and they cannot assume the liabilities of (or have their own liabilities assumed by) other public entities. This triple constraint places considerable political pressure both on Member State governments and on European institutions. The challenge is to ensure that all parties act within the spirit of the wider European project, including the economic and monetary union.

The distribution of sovereign debt holdings among central banks, domestic financial institutions, other domestic residents and non-residents is also important for the operation of any sovereign debt restructuring arrangement. By implication European policymakers face a complicated set of trade-offs between core European values. There is no single blueprint for a successful institutional arrangement for orderly sovereign debt restructuring. There are core areas of agreement on elements that should be included and procedures that should be followed, but there is also considerable political discretion in how they are assembled.

The question is whether sovereign debt restructuring is a priority matter for political attention either within the Euro Area or across the European Union as a whole. The answer depends upon understanding why sovereigns might need to restructure their debt and what will be the implications of sovereign debt restructuring for European integration. The causal mechanisms are both long- and short-term in development and relate to the building up of imbalances and the vulnerability of the markets – both psychological and real – to sudden shocks.

The European Union has developed strong frameworks for addressing the emergence of imbalances over the longer term. It has less robust institutions for handling short-term, exogenous shocks – particularly when those shocks fall on financial institutions. The progress made toward the completion of Europe’s banking union is impressive and yet there is still more to be done. Specifically, European politicians should focus on measures that will bolster investor confidence in the robustness of integrated financial markets. The completion of Europe’s banking union will provide one important area of progress. The creation of a common risk-free asset is another area that warrants attention. The use of European financial resources to bolster long-term infrastructure projects at the Member State level is important as well.

The full text of the briefing note is published on the European Parliament’s website and can be accessed here.