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State insolvencies are largely uncontrolled now and don't follow any fixed rules. Bankruptcies are sometimes delayed, sometimes caused willfully and creditors are dependent on the goodwill of governments because government debt is not backed by state property and lenders have little leverage to take action against states to get their money back.
Martin Greive and Holger Zschäpitz report in Die Welt about two proposals for sovereign defaults, by the Cologne Institute for Economic Research and by the German lawyer Christoph Paulus.
It all starts with Greece. Greece's creditors agree in one respect, that the country's debt is unsustainable, but disagree on how to restructure it and especially on which lenders should take losses –
The IMF does't want to participate in a third rescue package without a haircut. Berlin is unwilling to forgive Athens' debt for the time being.
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Several members of Germany's conservative CDU led by pro-business Carsten Linnemann have had enough of the ad hoc rescue policy and demand clear and transparent rules to deal with problem countries and avoid a transfer union. A state insolvency procedure must ensure that the only possible outcome of a sovereign debt crisis inside the euro zone is a successful restructuring or an orderly exit.
The Cologne Institute for Economic Research (IW Köln) has prepared a proposal.
According to their plan, state insolvency proceedings could be started by an over-indebted country, but also - crucially - by the European rescue fund ESM, which could force the country into proceedings in order to avoid a wrongful delay. The country would first negotiate alone with its creditors. If there is no result, a newly created chamber at the European Court of Justice would follow up the negotiations as an advisor and make a decision against the will of debtors and creditors if they can't agree on a solution. The insolvent country would receive temporary financial assistance from the ESM, but as usual this would be conditional on a strict reform program.
They acknowledge their proposal is not risk-free. According to the Welt article, they fear
- a problematic redistribution at the expense of creditors (My note: would it be an insolvency procedure if creditors didn't take losses?)
- that states could have an incentive to get over-indebted if they have the prospect of debt relief (Sovereign states already have the prospect of debt relief because they can choose to default unilaterally. The proposal of the Cologne Institute would actually reduce the prospect of debt relief for euro zone countries)
- that investors could withdraw from government bonds if they have to fear being dispossessed more frequently (My understanding is that private investors are reluctant to lend money to over-indebted countries but restart lending to them after a default)
Therefore, the Cologne Institute thinks their insolvency proceedings should only be introduced after the states reduce their high debt levels and banks and insurance companies are more capitalized to absorb losses from a sovereign default. Also, government bonds of euro area countries should no longer be regarded as risk free by the balance sheet regulation and should be backed by equity.
The ECB plays an important role in the plan. The currently ongoing government bond purchase program should be used to reduce the current high stock of government bonds in the banks' balance sheets.
Greive and Zschäpitz write that the German Finance Ministry regards the discussion about a state insolvency procedure as important, but remains sceptical because it would be a strong interference in one of the sovereign rights of the parliament (in the singular, the German parliament is probably meant here), budgetary sovereignty. An insolvency procedure faces considerable political and constitutional obstacles.
According to Greive and Zschäpitz another difficulty is that if creditors were expected to take greater losses they would distinguish accurately between the debts of the individual euro countries and interest rate differentials would soar. (Again, the insolvency procedure is meant to protect creditors by minimizing their losses. Why should creditors take greater losses as a consequence of the procedure?)
The proposal of the German lawyer Christoph Paulus is similar to that of the Cologne Institute. An over-indebted country would be able to initiate bankruptcy proceedings. The International Monetary Fund (IMF) would assess whether the country has done so fraudulently and has hidden assets somewhere. If this is not the case a European arbitration court staffed with elder statesmen would mediate in the negotiations between the state and its creditors.
