Will the ESM guarantee Eurozone bonds?

By Felix Salmon
December 7, 2011
Simone Foxman has got her wonk on and is getting into the weeds of Eurozone bail-in policies -- a crucial subject about which there isn't nearly enough public coverage.

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TBI’s Simone Foxman has got her wonk on and is getting into the weeds of Eurozone bail-in policies — a crucial subject about which there isn’t nearly enough public coverage. Simone says that I’m wrong, and that the EU is in no way intending to guarantee the debts of the PIIGS. And I very much hope that she’s right about that.

Part of the problem here is that we’re all just working from whispered and unsourced news reports: it’s not like there’s any clear public language about what Merkozy is proposing. And even if there were, it would of course be subject to change over the course of the current negotiations.

Foxman points me to a form of words in an official Eurogroup statement from November 28:

Rules will be adapted to provide for a case by case participation of private sector creditors, fully consistent with IMF policies. In all cases, in order to protect taxpayers’ money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan.

And today there’s a letter from Merkozy which is even more opaque:

As far as the private-sector involvement is concerned, the ESM treaty should be revised to make clear that Greece required a unique and exceptional solution. We recall that all other Euro area Member States reaffirm their inflexible determination to honour fully their own individual sovereign signature. A recital in the preamble should clarify that the euro area will apply the IMF practice. As agreed, common terms of reference on CACs shall be introduced in national legislations.

The good news here is that it looks like there won’t, after all, be anything like an explicit Eurozone backstop of all members’ sovereign debts: the only thing which is abundantly clear about both of these formulations is that they’re explicit about absolutely nothing.

For one thing, the idea that anybody could turn to “IMF policies” for guidance on these matters is laughable: there are no IMF policies on the subject, beyond a general rule that the IMF itself won’t lend to a country which is in default to its private creditors. (And even the IMF seems happy to break that rule when it needs to.) As for “IMF practice”, that basically means a case-by-case “we’ll cross that bridge when we come to it” approach. Which is reasonably sensible.

So I suspect that the “IMF policies” language is going to stay in there, precisely because no one really has a clue what it means. I doubt, however, that we’ll keep the bizarre notion that that the ESM will both have preferred creditor status and be junior to the IMF. The whole point of preferred creditors is that they never take losses, while the whole point of being junior is that you might take losses. I’m pretty sure that the IMF would be very unhappy indeed with the precedent-setting idea that a preferred creditor could accept a haircut, even if that preferred creditor was not the IMF itself.

And meanwhile, the “inflexible determination to honour fully” sovereign debts is being devolved down to the individual member-state level, where it has always been, rather than being run up to the EU level.

So where does this leave private-sector bondholders? They could still get bailed in if the ESM takes a haircut — but the ESM is clearly determined not to take a haircut, as is evidenced by its attempt to give itself preferred creditor status. But if a Eurozone country gets into fiscal trouble and is forced to hand over a certain amount of fiscal sovereignty to the EU, will the EU then force that country to restructure its bonds? My feeling here is that the answer is no.

If the ESM goes according to plan, then basically what happens is that the EU as a whole steps in when a country can’t get its fiscal act in order, and takes over to provide adult supervision and to force hard decisions to get made. One of those decisions will be to honour fully all sovereign debts. Ex hypothesi, the country in question can’t roll over those debts — which means that the ESM will have to step in to fund all budget deficits. And so even as private-sector debts are coming due and being rolled off, the ESM will be providing new-money funding.

All of which looks very much like an EU guarantee of sovereign debt.

But at the same time, the chances of the ESM going entirely according to plan have to be reasonably slim. And there’s enough wriggle room in the language as currently envisioned that if things start going really pear-shaped in Italy or Spain, private-sector bondholders could still see themselves forced to accept some kind of haircut.

It would just take the failure of the ESM for that to happen.

So is the ESM an EU guarantee of all Eurozone sovereign debt? To a first approximation, if it works, then I think it probably is. But it’s not a blanket, iron-clad guarantee. And that, at least, is good news.

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