The Euro Zone Crisis

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The Euro Zone Crisis : Debts, Institutions and Growth Agnès BÉNASSY-QUÉRÉ and Laurence BOONE Le Cercle des Économistes

How we got there The deep crisis the Euro zone has experienced since 2009 is not just a side effect of the global crisis. True, the global crisis has had a strong impact on government debt-to-GDP ratios, inflating the numerator while the denominator was negatively impacted. However, the seeds of the crisis are to be found in the Euro zone construction itself–a monetary union with no fiscal federalism and weak government coordination. Three elements proved key in this respect : 





First, the benign attitude of European partners towards cumulative macroeconomic imbalances in some member States. Yet it was known that the monetary union could prove destabilizing in higher-inflation countries that would enjoy low, possibly negative real interest rates that would encourage leverage and demand from the private sector. Second, the failure of the Stability and Growth Pact (SGP) to foster fiscal sustainability. In some member States, this failure was related to fiscal profligacy (which was also encouraged by low interest rates); in others, fiscal discipline proved partially flawed, based on inflated receipts in relation to overheating economies cum asset-price bubbles, and disregarding off-balance sheet liabilities such as explicit or implicit guarantees extended to banks. Third, the lack of a provision in the Treaty for sovereign insolvency. The authors of the Treaty had well understood that insolvency from one member State would put the monetary union at risk because sovereign bonds were to be disseminated within the European, integrated financial system: to avoid a financial crisis, there would be strong pressure on partner countries for a bail out, and on the ECB for monetization. To avoid both, bail out and monetization were (almost) proscribed in different articles of the Treaty. But no provision was taken for the way to deal with a sovereign insolvency: the very possibility of insolvency would supposedly be excluded through the enforcement of the SGP.

The Greek sovereign debt crisis found European partners unequipped. They could have fully externalized the resolution of the crisis through letting the International monetary fund tackle the crisis alone. This solution would have had several advantages. First, it would have speeded up financial support, hence reducing the final cost of the crisis. Second, it would have avoided infringing the spirit if not the words of the Treaty. Third, it would have focused social anger against the IMF, preserving public opinions on European integration both in Greece and in partner countries (especially in Germany). However, relying on the sole IMF would have meant that the EU was not able to manage a crisis by itself. More importantly, an IMF package would have incurred the risk of being too small, hence unable to avoid debt restructuring. Debt restructuring was believed to be a very damaging outcome of the Greek 1

crisis, due to possible contagion to other countries and because the EU banking system, which holds a significant part of the debt, could have been destabilized again by the corresponding losses. Having rejected a pure IMF solution, EU member States had no other choice but to circumvent the Treaty. Together with the IMF, they extended loans to Greece and then designed a mechanism to be able to help any country in trouble (see Box 1); and the ECB stepped in through outright purchases of troubled government bonds. Admittedly, EU partners did not bail out Greece, but just provided loans that are to be repaid; as for the ECB, it did not buy government bonds directly from the troubled States, but on the secondary market, and it was careful to sterilize its interventions. However it is difficult to deny that at least the spirit of the Treaty has been violated.

Why the problem has not been fixed yet Because there existed no plan in the first place to fix the problem, it took several months to EU partners to come with solutions. As evidenced in Figure 1, sovereign spreads started to widen in late 2008, but it was only in early May 2010 that rescue plans were announced, supplemented with decisive action by the ECB to stabilize sovereign bond markets. Figure 1: Euro area government (10-year) spreads (in basis points)

Source: Thomson Datastream

The EU-IMF 3 and 9 of May plans aim at subtracting the countries in difficulty from market dependency during a couple of years, conditional on fiscal adjustment: the idea is to provide loans at fixed interest rates in order to ensure that fiscal adjustments are not absorbed by skyscraping debt service (see Box 1). After the plan is over, the different countries will hopefully display healthier public finances that will allow them to raise money at reasonable rates on the bond market. The problem with this scheme is that historical experience suggests that large fiscal adjustments are indeed possible but they take much more than a couple of years (see 2

below). In addition, the Greek crisis has triggered a burgeoning of fiscal adjustment plans across the EU, each government feeling concerned by possible downgrades by rating agencies. Taken together, these plans have induced a fear that the EU would be left behind in global recovery, and that slow growth would contradict government efforts to adjust public finances. Hence, three major issues are under scrutiny: 1/ the continuation of the sovereign debt market despite rising concern that the sovereign debt of some countries could need restructuring over the next couple of years; 2/ a plan for coordinating adjustment policies in the short-to medium-term without killing the seeds of growth; 3/ a longer-term framework of economic governance or integration that will ensure further structural convergence across euro countries.

The continuation of the sovereign market The persistence of wide government bond spreads has evidenced that, despite EU-IMF announcements, markets still attribute a non-negligible probability to a scenario of debt restructuring. The main reason for the governments and the Central Bank to do everything they can to avoid such a scenario is the risk of a second, Lehman-type systemic crisis. Indeed, financial integration has worked its way throughout the euro area. As evidenced in Table 1, the bulk of government bills and bonds of euro-periphery countries are held by nonresidents. Among them, around 50% are held within the euro area countries. Debt holdings are spread across financial institutions, as suggested in Figure 2 in the case of Greece: the Euro zone (excluding Greece) is estimated to hold 56% of the Greek government debt, and 44% of these holdings would be in banks balance sheets. Detailed estimates reported by European banks suggest that, although a Greek default or restructuring could be absorbed1, a default or restructuring extended to several countries would be likely to trigger a second bank crisis. For example, according to the Bank of International Settlements2, total bank exposure of France and Germany to Greece, Portugal, Ireland and Spain, including direct debt holdings and exposure through branches, represents around 15% of their GDP. Hence, even very limited haircuts on several troubled government debts would put the Euro zone’s banking system at risk. This means that in the worst-case scenario, the amount needed to recapitalize banks in France and Germany could even downgrade French and German government signatures. At least, both governments would face serious discontent at home. Before bank recapitalization can be completed in the Euro zone, there were two short-term policy options. The first option consisted in organizing the sovereign default of the smallest, most troubled countries in such a way that it would not spread over large countries through market contagion. This was a perilous route as there are many such contagion channels. One possibility would have been to create one or several “bad banks” or dedicated funds that would have offered exchanging the bonds of some troubled countries for claims on the fund, with a significant haircut, thus acting as a backstop against capital losses (see Gros and

1

For instance, a 50% haircut on Greek debt (which is the average size of restructuring that took place in previous countries, see Moody’s March 2009, “Sovereign default and recovery rates, 1983-2008), and assuming Greek debt holding by banks have been halved between 2009 Q3 and the date of restructuring, the loss would amount to c.€4bn for the French or German banks, which is manageable. 2 Bank of International Settlements, “Detailed tables on provisional, locational and consolidated banking statistics at end-December 2009,” Monetary and Economic Department, April 2010. 3

Mayer, 2010 3 ). The problem with such scheme would be its financing relying on contributions by SGP-infringing countries, as proposed by Gros and Mayer, would be likely to prove insufficient in the short run. The second route was that governments take swift action to cover the refinancing needs of troubled countries before these needs become unbearable. This is the choice made by the EU council on May 9 2010, with the creation of a special purpose vehicle to raise funds in order to help troubled countries to meet their refinancing obligations, should markets fail to provide roll-over at reasonable cost (see Box 1). However it took a month before the governments could reach an agreement on the way this European Financial Stabilization Fund would be financed, delaying its operational start. Table 1: Share of government bonds that are held abroad, in percentage % Bonds % Bills % Total Debt Portugal

88%

88%

72%

Ireland*

87%

84%

86%

Spain

60%

39%

60%

Greece

84%

NA

75%

Italy

50%

47%

55%

Note : Total debt includes loans and other non-marketable debt on top of marketable debt, which explains why there can be external debt as % total debt, which is smaller than the amount of bond and bills held externally. *: Q3 09 except for Ireland end 2008. Source: Barclays Capital Figure 2: Estimated government securities holdings at end Q3 2009 (€ bn) 180 160 140 Others Monetary authorities Other institutional investors Insurance

120 100 80 60

Banks

40 20 0 Greek residents

Euozone (excl. Greece)

UK

RoW

Source: Barclays Capital.

3

Daniel Gros and Thomas Mayer, How to deal with sovereign default in Europe : Create the European Monetary Fund now!, CEPS Policy Brief No. 202, 17 May 2010. 4

Given the urgency of the situation, and taking into account the time needed to set-up the inter-governmental scheme, the ECB also stepped in on May 10, 2010. The decision to start acting as a “buyer of last resort” of Greek or other euro-periphery debt (Box 2) was not taken without long internal discussions. Although the Treaty does not rule out the ECB buying government bonds on the secondary market, the Central Bank had so far refrained from doing so (as opposed to the Federal Reserve and the Bank of England), because this would have brought it very close to a monetization of government debt. However the ECB’s mandate includes both price stability and financial stability. Price stability not being at risk, it had rooms for maneuvering to impede a major systemic crisis, in the absence of an operational EU-IMF plan. There were two main reasons for the ECB to get involved. Firstly, the Greek bonds needed a market price for valuation in banks and other financial institutions books. Secondly, this was a way for the ECB to signal its flexibility and ability to intervene on other countries sovereign debt should it be necessary (the ECB also bought Portuguese and Irish bonds). Thus the ECB bought for close to 40bn euros of these three countries’ debt in the first four weeks of its purchasing operation, with very little haircut. To avoid the transfer of risk from the banks to the ECB, the latter could have imposed a more sizeable haircut on its purchases. However this would have been in sharp contradiction with ECB’s official trust in the Greek fiscal adjustment plans. Additionally, it would have been a risky strategy in terms of contagion effects. The U-turn operated on May 10 has raised a number of concerns. As long as growth remains subdued and the amount of slack in the economy is large, the risk for inflation is unlikely to materialize.4 A more serious concern is the deterioration of the ECB’s balance sheet. Given the limited amounts involved,5 the risk is not so much that of a capital loss by the Central Bank and subsequent needs for recapitalization than that of moral hazard, European banks being keen on transferring risk at no cost to the Central Bank. In addition, should a restructuring materialize, some fear that the ECB may then act (temporarily) as a bad bank. ECB’s intervention will not have large, long run implications if it remains limited in time and in amounts involved. Being independent, the ECB was able to act much faster than governments. But this strength could become a weakness should governments find debt monetization much more comfortable than a large bailout: procrastination by governments would force the ECB to remain the only pilot of the plane.

Kick-starting fiscal adjustment without killing the seeds of growth Following the financial crisis, and as is usual in similar situations, the debt-to-GDP ratio across area countries will have increased in three years by about 20 percent of GDP. If debtto-GDP ratios had been low before, or structural deficit reduced, this would not be such an issue, as debt ratios would have remained stable at higher level than before, but reasonable 4

The fact that bond purchases have been sterilized may not be the crucial feature here since the ECB has simultaneously re-opened its fixed-rate, unlimited allotment refinancing operations (see Guido Tabellini, “The ECB: Gestures and credibility”, Vox, 26 May 2010. 5

Less than €40 bn during the first month, amounting to 0.4% of Euro zone’s GDP, to be compared with 14% of GDP in the UK and 12% in the US. See Paul Meggyesi, “How lite is the ECB’s QU-lite?”, J.P. Morgan Global FX Strategy, 4 June 2010. 5

levels. However, some countries already had high debt ratios or elevated structural deficit; others had relatively low public debt ratios, but high private debts, hence a large potential for deleveraging producing low GDP growth. In both cases, the financial crisis put the debtto-GDP ratios on an unsustainable path. In the wake of these events, not only Greece but also Spain, Portugal, and to a lesser extent other euro area countries, announced austerity measures, with the risk of putting a halt to the fragile economic recovery. The fiscal restrictions announced as of May 2010 pile up to 7% of GDP in Greece, 3% in Ireland, 2.5% in Portugal and Spain in 2010 (Table 2). These are very large amounts for the four countries, but given still expansionary or neutral fiscal stances in other Euro zone countries, the aggregate tightening will be very limited in 2010 (only 0.2% of Euro zone GDP, see bottom line of Table 2). In 2011, all Euro zone countries will join the group of adjusters although at a more moderate pace. Although the process of drafting the 2011 budget is still at an early stage, currently it can be anticipated, based on measures so far announced, that the marginal amount of additional fiscal tightening in 2011 would be around 1% of GDP.

Table 3: Euro area fiscal tightening announcements as of May 2010 Discretionary tightening (change in fiscal stance, including one-off measures, % GDP) Reference year 2010 2011

2012

2013

Austria

-0.5

0.2

0.5

0.5

Belgium

0.7

0.5

0.5

0.5

Finland

-1.0

0.2

0.0

0.0

France

0.0

0.6

0.6

0.6

Germany

-1.5

0.4

0.4

0.4

Greece

7.0

4.0

2.0

2.0

Ireland

3.0

2.0

1.5

1.0

Italy

0.5

0.8

0.4

0.4

NL

-1.0

0.7

0.7

0.7

Portugal

2.5

3.1

1.5

1.5

Spain

2.5

2.9

2.0

2.0

Others

0.3

0.5

0.5

0.5

Euro area

0.2

1.0

0.7

0.7

Source: Barclays Capital, based on updated national stabilityprograms and governments announcement post 9 May

Fiscal adjustment and growth The IMF review of past adjustments, both in emerging and developed economies,6 suggests 6

International Monetary Fund, “From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies,” Fiscal Affairs Department, 10 April 2010. 6

that successful adjustments (in the sense of ensuring a debt reduction of about 8% of GDP, but up to 20% in the case of Ireland) share the following characteristics :  The length of the adjustment is on average 7 years;  About half of the adjustment is due to a reduction in primary expenditures, most of which consisting of wage bill cuts and reductions in social expenditures;  Most of these adjustments took place in the 1990s, at a time when interest rates were on a declining path, which supported a reduction of the private sector saving towards consumption (in most cases domestic demand continued to increase);  In a large sample of countries, there was a depreciation of the exchange rate (from 6 to 20% in the Scandinavian economies).  Overall, in most cases, there was no more than one year of negative (real) GDP growth and in some cases, real GDP growth never turned negative. This is due to the combination of resilient internal demand (thanks to the decline in interest rate) and growing external demand (partly thanks to the real exchange rate depreciation). The current episode is different in the sense that countries in the euro area cannot devalue vis-à-vis their main trading partners who also are in the euro area, and interest rates are already at record low. The fiscal adjustment thus runs the risk of engineering a severe contraction. To avoid this, the euro area must find ways of 1/ engineering an internal devaluation for those countries in need of strong adjustment, 2/ getting the support of euro area and the rest of the world demand, to compensate somewhat for the decline in internal demand. In an analysis of Portugal, Blanchard (2007) suggested that since the devaluation could not be obtained through the exchange rate, competitiveness gains could arise from internal devaluation. He suggested that a large cut in nominal wages and in the prices of nontradable goods would induce a reduction of all prices and revive competitiveness. An alternative to a nominal wage cut (or rather a supplement) would be a switch of payroll taxes for VAT (although the higher the existing VAT rate, the more difficult this is to implement). An internal devaluation would rely on a simultaneous change of all prices in Greek-law contracts, including debt contracts. Such a change would raise difficult judiciary issues, but a temporary or definitive leave of Greece from the Euro zone would raise similar issues (since this would amount to changing the invoicing currency of all contracts), with additional costs i.e. in terms of interest rates or access to liquidity. An internal devaluation would produce immediate adjustment while preserving the benefits of euro membership. In the absence of an internal devaluation, a progressive depreciation can be obtained through deflation. It should be noted here that the speed of this form of adjustment will depend (i) on the exchange-rate of the euro, a weak euro participating to price competitiveness vis-à-vis non-Euro zone countries, and (ii) on the inflation rate of Euro zone partners (more inflation in Germany and France making it easier for periphery countries to adjust). The latter point is likely to be non-consensual, core-euro countries being keen to favor price competitiveness as a key element of their exit strategies. Finally, the cost of fiscal adjustment in periphery countries can be reduced by the lack of monetary policy tightening and by limited fiscal tightening in those countries where fiscal adjustment is less urgent. The timing of monetary tightening will depend on the evolution of inflation. Because inflation in turn will depend on the output gap in the euro area, too early monetary tightening is unlikely to be a concern (should the ECB hike interest rates, this 7

would be related to fast recovery). On the fiscal side, things are different in particular due to the introduction of national fiscal rules: it is unlikely that core-euro countries will weigh the situation of periphery countries when they decide to reduce their own deficits. Still, some coordination could be organized around the composition of receipts and expenditures, and on demand-friendly structural reforms. On the receipt side, spreading the effort across the different tax bases (rather than, as has already started, relying on VAT hikes) could help reviving domestic demand. On the spending side, preserving public investment in infrastructure and education would be key to help recovering a dynamic potential growth path. Finally, structural reforms could help to raise both long run and medium-run growth prospects, for instance through facilitating hiring or liberalizing some services sectors7.

The way forward: economic governance and integration ? At the onset of the euro, economists warned that it would be difficult to run a single currency without a federal budget, or more labor market flexibility, or marked divergence in the economies’ competitiveness. The Stability and Growth Pact substituted for budgetary integration. The Lisbon agenda and Broad Economic Policy Guidelines were introduced with a view of fostering labor and product market flexibility, thus enhancing countries’ competitiveness. Yet, both the SGP and the Lisbon Agenda turned out to be weak instruments. There are two problems with the coordination scheme: lack of enforcement, and misguided surveillance. Lack of enforcement So far, the enforcement of the SGP has relied on fees, while the BEPG and Lisbon agenda have relied on peer pressure. Both enforcement devices have shown their limitations. This suggests two different routes that could possibly be combined : 



Tighter sanctions: without going as far as depriving a member state from its voting rights, sanctions could target EU support more directly (suspension of CAP or structural funds support) rather than asking troubled governments to pay a fee (and ultimately having the fee socialized through rescue plans!). Sanctions could also be swifter, e.g. starting before the 3%-of-GDP deficit bound is actually breached, with fast implementation, contrasting with the present delay of three years included in the SGP;8 Incentives: while incentives have proved efficient in the run-up of EU and EMU membership, incentives are curiously absent from the coordination system in the Euro zone. Those countries that carry out fiscal adjustment programs could be rewarded e.g. by easier channeling of CAP or structural and cohesion funds for investment, as the adjustment measures are being implemented.9 Another way of providing incentives could be to allow countries to issue common euro zone bonds (or guaranteed bonds) beyond a certain threshold of debt, as suggested by Delpla and von Weizsäcker (2010).10 Debt in excess to the threshold would not benefit from the scheme, and the

7

See “International Monetary Fund”, Article IV consultation discussions with euro-area countries, 7 June 2010.

8

The decisions taken by the Euro group on 7 June 2010 to “upgrade” the SGP point to this direction.

9

For instance, the co-financing requirement could be reduced for those countries carrying out large adjustments as a way to encourage them to preserve investment spending. 10

Jacques Delpla and Jakob von Weizsäcker, “The blue bond proposal”, Bruegel Policy Brief, 6 May 2010. 8

risk premium attached to them would provide an incentive to adjust public finances. Misguided surveillance It is now widely recognized that focusing on public finances while disregarding private sector’s leverage proved wrong: Ireland and Spain, which perfectly complied with the SGP, fell in deep fiscal trouble during the crisis. Consistently, there is some consensus to broaden the scope of surveillance to intra-Euro zone competitiveness, private leverage, asset-price bubbles etc.11 The problem then is how to organize such surveillance which can no longer rely on a simple rule. One solution would be to rely on detailed assessments by the Commission. The risk would be that of a bureaucratic drift and/or that of the lack of legitimacy, national leaders being increasingly tempted to reject it altogether. Broadening the scope of surveillance hence raises the question of the institutions in charge. Integration or decentralization ? Recognizing the failure of the rule-based surveillance mechanisms, a natural avenue could be to move towards further integration. The proposal by the Commission, endorsed by the Euro group on 7 June 2010, to have national budgets reviewed before they are examined by national parliaments, points to this direction. Ideally, such an ex-ante coordination would carefully consider not only the aggregate amounts but the composition of the budgetary policy. De facto, it would tend towards more federalism, where countries would be ready to amend their economic policy in line with the “common welfare”. Given the loss of sovereignty this would involve, surveillance could no longer remain a technical exercise in the hands of the Commission; strong involvement by the Euro group and even the European Parliament would be needed. Consistent with further coordination of the decision-making, a financial backing system in case of crisis or difficult times could be made permanent, which would potentially involve transfers across Euro zone partners. The problem is that the crisis does not seem to have increased the appetite of member countries for more federalism or for more centralization. As argued by Pisani-Ferry (2010),12 the integration route is not the only one forward: “It is perfectly possible to imagine an alternative scenario where budgetary discipline would result from a combination of institutional reforms at domestic level and market forces.” This second route would be more akin to the European mechanism of financial surveillance. A common European framework would be set-up for processes and institutions. For instance, in each country, an (independent) Committee would review the short-term (cyclical) adequacy of the budget, the long-term sustainability of the public finances, but also (as is the case for the Swedish Fiscal Committee 13 ) the employment and growth developments and subsequent government policy proposals. Each national Committee would in turn report not only to the national parliaments, but also to a European Fiscal Committee that would evaluate and communicate on the aggregate result, with the technical assistance of the Commission. Thus 11

For instance, not all Euro zone countries experienced housing-price bubbles prior to the 2008-09 crisis. Those, like Spain, that experienced them could have taken action through the taxation and/or regulation of mortgages. The failure of the Spanish government to take action could have been pointed out and sanctioned, since it had a potential for spillovers on the rest of the Euro zone through the banking sector or, as was observed, a sudden stop in growth. 12 Jean Pisani-Ferry, “ What went wrong in the euro area? How to repair it ? ”, Notes for panel discussion on policy co-ordination in the euro area, Brussels Economic Forum, 6 May 2010. 13 See Lars Calmfors, “The Swedish fiscal policy council – Experiences and lessons”, Paper prepared for the Conference on Independent Fiscal Policy Institutions, Budapest, 18-19 March 1010. 9

each member states would remain free to implement its policies, but there would be an official and publicized assessment of their fiscal stance, more largely of their economic policy, at the national level, and with implications for the euro as a whole. Such lessdemanding coordination could maybe find its way more easily in national political arenas and gain the “ownership” of SGP and BEPG processes that has been lacking during the first decade of the euro. *** The Euro zone crisis is much more than a sovereign debt crisis. It puts into question the whole architecture of economic policy, from monetary policy to macroeconomic surveillance and sanctions. Beyond the short-run urgencies, EU members need to come out with a clear view of what kind of coordination device they want to invent. There are several routes forward, but failing to select one could contribute in marginalizing the Euro zone in the global economy.

Box 1. The European Financial Stabilization Mechanism On May 9, 2010, Euro countries and the IMF released a “massive”, joint rescue package. The package (which excludes the already-agreed €110bn for Greece) comprises up to €750bn of new money, based on the following : (a) The European Commission (EC) Balance of Payments (BoP) lending facility is expanded from its current limit of €50bn to €110bn;14 (b) Emergency financings worth €440bn will be provided via a Special Purpose Vehicle (SVP) financed through euro area government- guarantees bond issuance, each government extending its guarantee to up 120% of its share based on ECB’s capital structure. (c) An additional sum of around €250bn provided by the IMF. To put these measures into context, the 2010 financing needs of Greece, Ireland, Portugal and Spain are estimated to be about €200bn, or €145bn excluding Greece (which has already its financing needs for the next two years effectively met by the IMF/euro area program). Hence, in relation to the annual financing needs of these countries, the plan is very substantial (especially in providing a backstop facility for government financing for a couple of years). All member states benefiting from the support will have to abide by an IMF/EU conditional program as was the case of countries recently benefiting from a joint EU/IMF program.

Box 2: ECB actions decided on May 10, 2010 On May 10, 2010, the ECB announced the following measure aiming at ensuring the smooth functioning of the sovereign bond market : (a) Purchases of public and private sector securities under a Securities Markets Programme to ensure depth and liquidity in those market segments which are dysfunctional; 14

The facility is constrained at €110bn by the size of the EC's budget. 10

(b) A reactivation of three and six-month, fixed-rate refinancing operations with unlimited amounts; (c) A reactivation of the temporary liquidity swap lines with the Fed.

Box 3: a primer on government debt restructuring A successful restructuration needs to ensure 1/ the stability of the financial system, 2/ that the debt “post-restructuring” is on a sustainable path (but it will not save a country from the necessary fiscal adjustment). As a result, the government, the central bank of the concerned country and the creditors need to be involved in the negotiations. 



On the financial system side, bank must be ring-fenced to ensure that no deposit run is taking place and that the banking sector will continue to provide liquidity and loans to the economy (as a typical debt restructuring takes at least five to 6 months). A typical debt restructuring takes the form of an exchange of the existing bonds for new bonds with longer maturity and lower coupons. Extending the debt maturity will give breathing space for the country, which is in a phase of budgetary adjustment (for example, Uruguay extended the maturity date of each of its bonds by about five years). The coupon served on the new debt must be in line with growth prospects to ensure that interest payments are bearable. Finally, the restructuring must be of a size large enough to have an impact on the deficit (fostering the adjustment) and interest to be paid. Finally, it might be useful that some of the new debt be guaranteed (for example by the IMF or the EU, within the part of the existing package) as it helps ensure creditors will be able and willing to hold this longer-term debt.

In practice, sovereign debt restructuring is carried out the Paris club, i.e. the club of the main creditors of governments (while the London club takes care of private debtors). However a default by one Euro zone periphery country would likely involve both the Paris and London clubs, which so far have restructured much smaller amounts (figure 3). Figure 3 : the size of recent debt defaults is dwarfed compared with the current event $bn

for euro are states: actual outstanding public debt (end-09) Total defaulted debt

723

349 142 161

82

Spain

Portugal

Ireland

Greece

Ec'dor. (Dec 08)

Dom. R.(Apr 05)

5.7 1.6 3.2 Arg'tna (Nov 01)

Peru (Sep 00)

Ec'dor. (Aug 99)

Pakstn. (Jul 99)

Russia (Aug 98)

Ven'zla (Jul 98)

Ukrain. (Sep 98)

1.3 1.6 6.6 4.9

0.3

Urug'y. (May 03)

73

Source: Moody’s, Eurostat, Barclays Capital. Note that a default never concerns the totality of the debt outstanding.

11