“Will they, or won’t they?” That was the question that preoccupied global financial markets as investors around the world waited to see if Europe would approve the next installment of a bailout package that would allow Greece to avoid defaulting on its sovereign debt.
The overnight news is that Brussels has approved the package of measures identified by the Greek government. But, before global investors heave a collective sigh of relief, they should pause and reflect. After all, Greece faces a very difficult challenge ahead. Agreeing to measures is one thing; implementing them is an entirely different matter. And, over the past week, attitudes in other European capitals have hardened -- with demands for greater external oversight of Athens’ budget.
What is going on here? Part of the answer is that politicians in creditor countries are responding to taxpayer concerns that their hard-earned money should not be used to bailout their less industrious euro partners. There is something else at work, however. As Gavyn Davies notes in the Financial Times, the proposed bailout package would lead to the socialization of Greek debt as official sector exposure increases, private sector exposure falls, and the overall debt burden is only modestly reduced. Given the prospective increase in public exposure, officials in creditor countries are determined to safeguard public monies.
In the domestic context, the conditions, or covenants, written into bond issues of a firm are designed to limit the extent to which the borrower can shift additional risk to the bondholder. If the firm fails to honour its covenants, or defaults on promised payments, creditors can take it to court. The creditor-debtor relationship is a business transaction enforceable in law.
At the international level, in contrast, bond covenants or the conditionality of bailout packages are often viewed as an infringement on national sovereignty. Countries may agree to them, but do so reluctantly; often under the duress of eleventh-hour negotiations. On this basis, over the past several weeks, we have observed the gradual loss of Greek independence.
It has not gone unnoticed in Greece. To the average Greek citizen, it does not matter that the bailout conditions are being written in Brussels, rather than the financial markets of New York, London or Frankfurt. In fact, it may wound Greek pride more that the conditions now being imposed are dictated by European partners in Berlin and Brussels, rather than the financial gnomes of Zurich or the bond traders of Wall Street for whom it just business. Regrettably, but all too predictably, the result has been an increase in anti-German rhetoric; a rise of nationalism.
In such circumstances, investors understandably not only weigh the sovereign borrower’s ability to repay – the capacity of the economy to generate the revenues required to service the debt – but also the borrower’s willingness to repay. If the costs of meeting their obligations, including the perceived the loss of sovereignty that entails, exceed the benefits from maintaining its access to capital markets, governments may view default as the lessor of two evils. The fact that the proposed bailout socializes the claims on Greece, while doing very little to reduce the overall debt burden, may increase this risk. The political calculus here is depressingly familiar: Confronted with the certainty of a long, painful period of adjustment with little prospect of improvement under the terms of a bailout package dictated by others, or an uncertain, but independent, future free of the constraints imposed by the euro, many would chose the latter.
In contrast to a firm in default at the national level, however, there is very little that creditors of a sovereign borrower can do to enforce payment. Despite recent challenges to limit its scope, the doctrine of sovereign immunity – the legal principle that sovereign states are immune to legal challenges for the payment of claims – remains very much in force. Lacking other means to enforce payment, private creditors cut off credit. As a result, sovereign defaults, when they occur, are disruptive and typically entail a protracted period of negotiation with creditors to settle outstanding claims. The result can be a marked deterioration in the country’s economic situation, and the adoption of policies that create more disruption and reduce potential payouts to creditors. In the interim, uncertainty increases with possible negative effects on global growth and development.
A decade ago, following the Asian financial crisis, efforts were made to develop a framework for the timely, orderly restructuring of private sector claims on sovereign borrowers. The objective then wasn’t to relieve borrowers of their obligations; nor was the goal to interfere with the bonding role of debt, which would impair the efficiency of international capital markets and reduce the flow of capital to countries that use credit wisely to build infrastructure and protect their citizens from commodity price or other shocks.
The intent, rather, was to create an environment in which sovereign debt restructurings would be conducted quickly, efficiently and equitably with an appropriate balancing of stakeholders’ interests. That is what domestic bankruptcy legislation does in weighing whether a firm should be closed and its assets sold off or remain in operation, possibility with new management and creditors forced to write down claims. Equally important, such an environment would create incentives for borrowers in difficulty to restructure their debts earlier, before problems escalate into crises. And, because a framework for the timely, orderly restructuring of claims would reduce the likelihood of a socialization of debt problems, it could have the beneficial effect of encouraging private sector investors to better price risk and discipline the imprudent borrowing of profligate sovereigns by restricting access to credit – surely, one of the key lessons from the euro zone crisis.
While important progress was made, particularly in terms of the introduction of collective action clauses that facilitate the restructuring of bonds, efforts to build such a framework were swept away by the wave of liquidity that followed the dot.com collapse. We now know that the stability that this surfeit of liquidity created was illusionary; indeed, today we are living with the consequences of excessive risk taking and the increased levels of public debt that resulted from efforts to prevent global depression.
As G20 finance ministers and central bank governors meet on the weekend in Mexico, therefore, they should heed former White House chief of staff Rahm Emanuel’s warning that you should never allow a serious crisis to go to waste. They should reflect on the opportunity to fill a basic gap in the governance of the global capital market that was lost a decade ago and resolve to do better.
They would be joining illustrious company: Adam Smith, who long ago proposed applying the principles of bankruptcy to sovereigns in financial distress as less costly to their citizens and their creditors, recognized that his “invisible hand” sometimes needs the all-too-visible hand of rules enforced by the state to advance the common good.
James Haley is director of the global economy program at the Centre for International Governance Innovation (CIGI)