Europe’s New Sovereign Default Regime

by Shane Fitzgerald

Trinity College Dublin’s Institute for International Integration Studies and its Policy Institute jointly hosted a seminar yesterday on the European sovereign debt crisis. Chaired by Prof. Philip R. Lane, the seminar heard from a host of leading international experts.

First up was Peter Boone, a senior fellow with the Peterson Institute for International Economics and a principal of Salute Capital Management. Boone is one of the authors of the influential Baseline Scenario finance and economics blog and has previously made some excellent contributions to the Euro crisis debate.

His presentation yesterday described how the EU has evolved from a regime that refused to countenance sovereign default to one where sovereign default is not only allowed in certain circumstances, but is in fact encouraged when politically and economically expedient. Because of the haphazard way in which we have moved to this new regime, there is no credible and consistent decision-making system around when and how a default should happen.

Effectively, he argued, a new clause has been added to European bonds:

“In the event that the issuing sovereign cannot adequately finance itself in markets at reasonable interest rates, and if a sufficient plurality of the EU Council of Ministers/Eurogroup/ECB/IMF determine it is economically or politically expedient, then this bond will be restructured.”

P.S. If the above clause is triggered then (i) the bond holder is junior to all official creditors if the official creditors so decide, and, (ii) the issuer reserves the right to change law as needed to negate any rights of the bond holder.

This clause fundamentally degrades the entire European bond market. Why should investors choose to hold, say, Italian bonds, under the above conditions?

Boone therefore argued that, no matter what happens at today’s summit, risk premia will stay high, causing credit contractions in troubled nations and disappointing growth throughout the EU.

He urged caution over ‘big bazooka’ solutions, arguing that investors are likely to use a mooted ‘€2 trillion backstop’ as a way to sell out of European bonds altogether. No amount of bank recapitalization will make investors comfortable with bank debt if sovereign risk remains large, he added.

In conclusion, he argued that if a breakup of the Eurozone or a rash of defaults throughout Europe is to be avoided, then the ECB must be persuaded to provide a lender of last resort function in a much more committed fashion.

Boone’s presentation (pdf) was followed by remarks from Mike Dooley (formerly of the Federal Reserve and the IMF), Ciaran O’Hagan (Head of Euro Rates Research at Société Générale), and Jean Pisani-Ferry (Director of Bruegel). Their slides can be downloaded here. Read Brendan Keenan’s review of the seminar in the Irish Independent here.

 This article was first published by the Institute of International and European Affairs. Access the original here.