DR RAM MANOHAR LOHIYA NATIONAL LAW UNIVERSITY, LUCKNOW

2022-2023

INTERNATIONAL BANKING AND FINANCE

PROJECT

SDRM IN EUROPE AND THE POLITICS AROUND IT

SUBMITTED BY: SUBMITTED TO:

I would like to convey my heartfelt gratitude to Mr. Bhanu Pratap Singh for his tremendous support and
assistance in the completion of my project and for providing me with this wonderful opportunity to work on
a project with the topic Food Culture during the Pandemic. The completion of the project would not have
been possible without their help and insights.

KISHALAYA PAL
INTRODUCTION

The potential role to organize debt restructuring for the euro area in an orderly way. 1
Academia’s keen interest in sovereign debt restructuring mechanisms (SDRM) for the euro area stands in sharp contrast to
the topic’s neglect among EU institu- tions. The European Commission’s “Reflection Paper on the Deepening of the
2
Economic and Monetary Union” is an illustrative example. The paper is highly ambitious with respect to the completion of
the bank- ing union (European Deposit Insurance Scheme), new debt instruments (sovereign bond-backed securities), a new
macroeconomic stabilization function (e.g. a Euro- pean unemployment insurance scheme), the establishment of a European
Monetary Fund (EMF) or the establishment of a euro area Treasury. At the same time, it does not include any hint to the
possible role and organization of an SDRM. The Com- mission’s disregard of issues related to debt restructuring continued in
the “Saint Nicolaus’ package”, the comprehensive set of detailed EMU reform plans presented by the European Commission in
December 2017. Once again, it offered no solutions on how to cope with an insolvent euro area government. Even the massive
fiscal solvency shock as a result of the Covid-19 pandemic has so far not triggered a new European SDRM debate.
One obvious explanation for this reticence of European political institutions is the fear that the mere existence of an SDRM
could destabilize government bond mar- kets. But this does not suffice to explain why European institutions hardly discuss the
issue. Recent academic studies on a European SDRM are fully aware of its chal lenges and have offered various strategies for
coping with the problems.
This article provides political economic explanations for the divergent positions taken by various parties on explicit
sovereign debt restructuring in a future EMU. It covers the following key players: the European Commission, the European
Parlia-ment, the European Central Bank (ECB) and the governments of high-debt and low- debt euro area countries.
The political economy of an SDRM has received substantial academic attention in the context of the IMF model for
developing and emerging countries proposed in 2002. The IMF model wanted to address the procrastination prob- lems with
over-indebted economies. Too often, countries with unsustainable debt levels delayed restructuring to the detriment of both
creditors and the domestic economy. Proponents of an SDRM wanted to promote a predictable, orderly and rapid restructuring
that could overcome the coordination failures of ad hoc debt negotiations. After an intense debate, the Krueger SDRM model
failed to gain suf- ficient political support from key players.3 Borrowing developing countries were afraid to lose
sovereignty as the IMF would have gained jurisdiction over domestic-law debt and exerted an even stronger impact on
domestic policies. Creditor countries were concerned about the moral hazard effects of possibly too quick and generous
restructurings and, not unlike borrowers, the growing IMF power. Moreover, the US administration under President George
Bush favored contractual market-based solutions instead of a stat- utory restructuring mechanism and, therefore, pushed the
use of Collective Action

1
Bénassy-Quéré, A., Brunnermeier, M., Enderlein, H., Farhi, E., Fuest, C., Gourinchas, P.-O., et al. (2018). Reconciling risk
sharing with market discipline: A constructive approach to Euro area reform. CEPR Policy Insight, 91.
2
European Commission. (2017). Reflection paper on the deepening of the economic and monetary union, COM(2017) 291 of 31
May 2017, Brussels.
3
Quarles, R. (2010). Herding cats: Collective-action clauses in sovereign debt—The genesis of the project to change market
practice in 2001 through 2003. Law and Contemporary Problems, 73(4), 29–38.
 Clauses (CACs) in bond contracts. The shifting attention towards CACs brought the IMF-centered SDRM debate to an end .
CACs can alleviate restructuring negotiations as they define creditor voting rules and qualified majorities of bondholders
that bind all bondholders within the same issuance to the restructuring terms. However, CACs are not at all a full substitute for
a fully developed SDRM since such a mechanism goes far beyond the definition of voting rules for bondholders: An SDRM
establishes a comprehensive framework to prepare, negotiate and execute a sovereign debt restructuring. It sets up institutions
and committees for the restruc- turing negotiations; it covers a wider range of sovereign debt instruments beyond bonds; like in
private insolvency procedures, an SDRM defines debtor information requirements and debtor protection with equal-treatment
of diverse creditors; it pro- vides temporary liquidity to the creditor over the period in which the restructuring procedure is
ongoing; and it sets incentives for prudent and responsible policies in the transition phase.4
This older IMF debate is a starting point for this analysis, which considers the support for a European SDRM in the
institutional context of the euro area. Like for the IMF SDRM, the debtor-creditor antagonism plays a key role in in the current
European setting. However, other issues of the earlier debate are of less relevance in Europe today. With strong supranational
EU institutions, the shift of power from the nation states to a higher level is already far advanced in Europe. Hence, one of the
key counter-arguments against the IMF SDRM—a loss of national sovereignty—is much less convincing in the current
European debate.
This study finds that the diverging positions are consistent with institutional self- interests. For the European Commission
and the European Parliament, the absence of debt restructuring increases the need for large and permanent centralized fiscal
instruments in line with the centralization interests of these institutions. The ECB position is ambivalent. From a monetary
policy perspective, the ECB has a strong interest in a smooth debt restructuring 5 whose burden falls on private investors in
order to avoid any monetary involvement in a bail-out. But the ECB today is mas- sively exposed to euro area sovereign debt
and might, therefore, fear write-offs that are likely to violate the legal ban on monetary financing. Moreover, the ECB likely
fears the fall-out of restructuring for banking stability given its banking supervision mandate.
For euro area governments, the case is asymmetric, but there is room for compro- mise. Low-debt countries fear the burden
of transfers if high-debt countries become insolvent and no credible restructuring mechanism exists. Conversely, high-debt
countries with a non-negligible risk of future insolvency prefer transfers over a debt cut, with all its economic and political
costs. The analysis concludes that a non- transparent transfer arrangement like the one applied in Greece could be an accept-
able compromise for everyone. Hidden transfers need substantive and permanent fiscal instruments, which are in the
centralizing interests of the Commission, the Parliament and the European bureaucracies. Hidden transfers avoid visible
problems for the ECB balance sheet and are not at odds with its banking supervision mandate 6. Moreover, hidden transfers are
in the interests of high-debt countries because they effectively reduce the debt-service burden. Finally, non-transparency helps
limit the

4
Niskanen, W. A. (1971). Bureaucracy and representative government. Chicago: Aldine-Atherton.
5
Vaubel, R. (1994). The public choice analysis of European integration: A survey. European Journal of Political Economy,
10(1), 227–249.
6
Zettelmeyer, J., Trebesch, C., & Gulati, M. (2013). The Greek debt restructuring: An autopsy. Economic Policy, 28(75), 513–
563.
political costs for incumbent governments in sustainable debt countries who have to bear the burden of the effective bailout.
The next section explains the role of transfers and debt restructuring in a Euro- pean fiscal union with regard to two
inconsistent taboos in the current reform debate. Section 3 looks in detail at the interests of important institutions. The
empirical sec- tion introduces the EMU Positions Database and tests several predictions. The final section examines the
implications for a possible compromise and discusses recent fiscal innovations in the corona pandemic in the light of the
paper’s findings and predictions.

1 Two inconsistent taboos

Talk of sovereign debt restructuring is not the only taboo in the euro reform debate. None of the important official EMU
reform templates includes any explicit transfer element. Any new fiscal capacities (e.g. European unemployment insurance) or
loan instruments (European Monetary Fund) are presented as part of an insurance narra- tive. The defining element of any
insurance scheme is that there is no systematic ex ante redistribution (from rich to poor or from low-debt to high-debt
countries). But an institutional arrangement that excludes transfers and sovereign debt restructur- ing simultaneously is
inconsistent.7 A consistent design can either exclude sovereign debt restructuring or exclude a transfer solution. But it cannot
coherently exclude both elements at the same time if there are (or could be in the future) cases of sovereign insolvencies.
Conceptually, a country is insolvent if the present value of future revenues does not suffice to balance the current debt stock
and the net present value of future expenditures, even for the maximum feasible fis- cal adjustment8
Three basic solutions are available for an insolvent country:

•
Unexpected positive solvency shocks Examples are structural reforms that are surprisingly courageous and successful in
boosting an economy’s growth poten- tial, technological innovations, the discovery of natural resources, and improve- ment
in terms of trade. Positive shocks of any such type could turn a situation of insolvency into solvency.
•
Debt restructuring (at the expense of private creditors) A debt restructuring that reduces the net present value (NPV) of
debt service obligations can restore debt sustainability. NPV effects can be achieved through multiple instruments:
haircuts that reduce the face value of a debt obligation; a maturity extension that postpones the repayment obligation; and
interest rate reductions. All these instruments involve redistribution from the lender to the borrower.
•
Transfers (at the expense of other jurisdictions’ taxpayers) In the absence of a positive solvency shock, the only alternative
to private creditor debt restructuring are transfers from other sovereigns.9 The insolvent coun- try can be rescued through
transfers from countries, international institutions and central banks. Transfers can have various forms and be explicit or
implicit and, hence, have very different levels of salience. A cash bail-out from other countries

7
Rodden, J. (2017). An evolutionary path for a European monetary fund? A comparative perspective. European Parliament In-
Depth Analysis, May.
8
Das, U. S., Papaioannou, M. G., & Trebesch, C. (2012). Sovereign debt restructuring 1950–2010: Literature
survey, data, and stylized facts. IMF Working Paper 12/203.
9
Zettelmeyer, J., Trebesch, C., & Gulati, M. (2013). The Greek debt restructuring: An autopsy. Economic Policy, 28(75), 513–
563.
 would be a particularly salient and direct way to reduce the debt service NPV. An identical effect can be achieved
through preferential loan assistance. Finan- cial assistance includes a transfer element whenever interest rates do not include
a risk spread that fully reflects the debtor’s credit risk. The transfer element in any such financial assistance amounts to the
face value of the financial assistance minus the NPV of the debtor country’s repayment obligation calculated on the basis of
a risk-adequate discount rate.

One important caveat relates to the difficult distinction between illiquid- ity and insolvency. The euro area debt crisis
with it panic-driven contagion in the 2010–2012 period has demonstrated that countries can fall victim to liquidity crises that
would be otherwise manageable in calm market environments. point out that a liquidity crisis can turn into a solvency crisis if,
for exam- ple, illiquidity forces a country to pursue austerity measures that damage a country’s long-run growth. According to
the multiple equilibria theory, a self-fulfilling proph- ecy may emerge in which a country becomes insolvent because investors
fear insol- vency. In such a case, preferential financial assistance may prevent insolvency in the first place.
De Grauwe and Ji clarify that past or future euro area insolvencies are not nec- essarily the result of a self-fulfilling
prophecy. In their multiple equilibria model, they show that the distinction between illiquidity and insolvency is blurry only for
an intermediate range of fundamental indicators. If the fundamentals deteriorate below a critical level, even optimistic market
sentiment cannot restore solvency.10 For these cases the only remaining decision is whether to pursue private debt restructuring
or transfers (of whatever type).
So far, there has been one instance in the euro area where debt sustainability was fundamentally lacking without reasonable
doubt: namely, Greece in 2010–2011. The experience with Greece confirms that any such situ- ation must trigger a debt
restructuring or a transfer solution. Interestingly, Greece underwent both debt restructuring and transfers. In 2012 the Greek
“private sector involvement” (PSI) restructured private Greek debt with a face value totaling more than 100 per cent of Greek
GDP. Depending on discount assumptions, the NPV loss imposed on private creditors was 50 per cent or higher. However, the
PSI was insufficient to restore solvency so that substantial implicit transfers were required as well. These were given by means
of preferential financial assistance from EU member countries (direct bilateral loans), ECB bond purchases through the
Securities Market Program (SMP), the European Financial Stability Facility (EFSF), and the permanent European Stability
Mechanism (ESM).
Given the current state of public finances in the EMU, more cases of fundamen- tally insolvent euro countries are likely in
the future. In its 2020 Debt Sustainabil- ity Monitor published before the outbreak of the Covid-19 pandemic, the European
Commission identifies persistent fiscal sustainability risks and identifies seven EU countries “at high fiscal sustainability risk
in the medium-term” including five euro area members. This debt sustainability analysis explicitly took account of the
downward

10
De Grauwe, P., & Yi, J. (2013a). From panic-driven austerity to symmetric macroeconomic policies in the Eurozone. Journal
of Common Market Studies, 51(S1), 31–41.
 trend in government interest rates, which supports debt sustainability. Undoubtedly, with the pandemic and its massive fiscal
and economic fallout, risks for future insol- vencies in the euro area have further increased since high-debt countries such as
Greece, Italy, Spain and France have experienced a particularly severe and probably lasting economic damage from the
pandemic.11
If it is to develop a realistic overall strategy, Europe must prepare for new sov- ereign insolvencies beyond Greece.
Rejecting the SDRM for euro area countries with the argument that insolvencies will not occur in the future is wholly
unconvinc- ing. Given Europe’s currently further deteriorating fiscal conditions, it must either open the way for debt
restructuring or accept (implicit) transfers for future cases of insolvency.
In the next sections, I consider the interests of crucial players with regard to SDRs and transfers.

2 Interests of crucial players

2.1 European Commission

One of the European Commission’s main executive responsibilities is the adminis- tration of the EU budget. From a Niskanen
perspective,12 the Com- mission, as the central European bureaucracy, has an institutional interest in increas- ing the European
budget or developing additional European fiscal instruments under its (partial) control. It should thus have a “vested interest in
centralization”.13 Over the decades, there has been ample evidence that the Commission wants to strengthen fiscal power at the
European level. In past negotiations regard- ing the EU’s Multiannual Financial Frameworks (MFF) the Commission has pro-
posed budgets that have been larger than the budgets finally adopted. Moreover, the Commission is a long-standing advocate
of new revenue types for the EU budget. In its proposal for the next MFF covering the 2021–2027 period, it has included three
news types of own resources: a share from a tax on a Common Consolidated Corpo- rate Tax Base (CCCTB); a share of
revenues from the European Emission Trading System; and a “plastic tax”, a new national contribution based on the amount of
non-recycled plastic waste.14

2.1.1 SDRM

An SDRM for Member States would be a building block for a decentralized fis- cal constitution without the necessity of
significant European involvement. Debt restructuring solves the underlying problem of national overindebtedness by impos-
ing losses on private creditors. As such it is the necessary condition to avoid open or hidden transfers from other Member
States or the EU to an insolvent country. An insolvency system may still give some responsibilities to European institutions. In
such a scenario, the Commission or another European institution could play a role in orchestrating the settlement. In
addition, there might be the need for short-run liquidity assistance to a Member State in distress during restructuring
negotiations

11
European Commission. (2020b). European Economic Forecast, Autumn 2020 (p. 136). Institutional paper: European economy.
12
Niskanen, W. A. (1971). Bureaucracy and representative government. Chicago: Aldine-Atherton.
13
Vaubel, R. (1997). The bureaucratic and partisan behavior of independent central banks: German and international evidence.
European Journal of Political Economy, 13(2), 201–224.
14
European Commission. (2018). Proposal for a council decision on the system of own resources of the
European union, COM(2018) 325 Final, 2.5.2018, Brussels.
 . With a credible SDRM in place, there is no need to involve the European budget over a longer time period to cope with
insolvent Member States.
From the point of view of an institution whose interests lie in centralization, therefore, the establishment of a system with
swift restructuring for overindebted countries will not be the preferred reform scenario. Instead, the central European
bureaucracy is more likely to prefer reforms that will foster the growth of the EU budget or alternative euro area fiscal
instruments. From this angle, the EU bureau- cracy could see unsustainable debt in a Member State as an opportunity to
establish permanent bailout instruments at the European level.

2.1.2 Transfers

In principle, transfers could also flow through horizontal payments among Member States without any EU level involvement.
But horizontal transfers are not attractive for donor countries due to resistance among voters (see below). Furthermore, there is
no tradition of horizontal transfers in the European integration process. All exist- ing significant EU transfer schemes are
vertical: Member States contribute to the EU budget that pays out transfers mainly through its Common Agricultural Policy
(CAP) and its cohesion instruments. With these precedents, the European Commis- sion can be optimistic that any transfer
approach to an overindebted euro area coun- try will depend greatly on the European budget and/or other fiscal capacities at
the European level.

2.2 European Parliament

The European Parliament is obviously harder to position in the reform debate given the substantial heterogeneity of its
individual members. However, in all fis- cal debates involving the EU budget or the need for new European revenue sources,
the EP has an institutional interest in new and larger European fiscal instruments. Hence, its average position should be similar
to that of the Commission, i.e. contra SDRMs and pro EU-level transfers and other fiscal instruments (provided that the
Parliament has some control over them).

2.3 European Central Bank

During past crises, the ECB has assumed more responsibilities and introduced new unconventional instruments through which
it has operated on secondary markets for government bonds, giving it significant importance for financing euro area govern-
ments.15 In 2010, the ECB established and activated the Securi- ties Market Program (SMP), which purchased government
bonds from crisis coun- tries. At the height of the debt crisis in summer 2012, the ECB Council initiated the Outright
Monetary Transactions (OMT) program, which supports countries that have an agreement with the ESM. Though the OMT has
never been activated, its mere existence has played a major role in the post-2012 reduction of risk premi- ums in
government bond markets. From 2015 until the end of 2018 and again since

15
Drudi, F., Durré, A., & Mongelli, F. P. (2012). The interplay of economic reforms and monetary policy: The case of the
Eurozone. Journal of Common Market Studies, 50(6), 881–898.
 November 2019, the ECB and the eurozone national central banks have purchased euro area government bonds under the
Public Sector Purchase Program (PSPP). 16 For the allocation of purchases across countries the ECB Council has committed
to stick to the national shares in the ECB capital key. In March 2020, as a reaction to the pandemic, the ECB Council has
established another substantive asset purchase program, the Pandemic Emergency Purchase Pro- gram (PEPP) that buys
European sovereign bonds. Accumulated stocks of sovereign bonds in the Eurosystem balance sheets have reached 3.2 trillion
euro at the end of 2020 and purchases both from the PSPP and the PEPP increasingly diverge from the ECB capital key with a
significant overweight of the high-debt countries’ securities.
The second major extension of ECB responsibilities is the new role within the European Banking Union, giving it direct
supervisory responsibility for large sys- tematically important banks.17
In terms of the ECB’s institutional interests, the extension of responsibilities is a mixed blessing. The new role in banking
supervision implies higher budgets and an increase in the number of staff which, from a Niskanen perspective, is a welcome
development for career opportunities and bureaucratic morale.18 On the other hand, preference formation on euro area
developments becomes more complex in view of possible trade-offs between monetary policy objectives and financial sta-
bility. As a monetary policy institution, the ECB is responsible for keeping inflation close to its two-percent objective. As a
supervisory institution, the ECB is responsi- ble for banking stability. Major new banking crises would raise questions about
the effectiveness of ECB’s supervisory branch.
3 Conclusions

Realistically, additional cases of insolvent EMU countries cannot be excluded for the coming years in view of the poor state of
public finances in numerous euro coun- tries already before the pandemic, the unwillingness to create fiscal buffers during
times of prosperity, and the massive new solvency shock that has occurred since 2020. If the EU rules out an SDRM, transfers
are the only remaining alternative for these cases. If open transfers fail to receive political support in donor countries, hidden
transfers will be the compromise that satisfies all the political and economic constraints.
Various features of the new pandemic-induced European monetary and fiscal instruments actually point into the direction of
hidden transfers. With the new asset purchases under PEPP, the ECB has abandoned several earlier precautions against
excessive exposure to high-debt euro countries. The ECB Council has lowered the credit quality standards for eligible
securities and now accepts Greek sovereign bonds that previously, due to the country’s unfavora- ble credit rating, were
excluded. It has furthermore given up a strict allocation of purchases across countries according to the country shares in the
ECB capital key and effectively overweights high-debt countries. Moreover, the ECB had to accept that the Eurosystem’s
holdings of euro area government bonds surpass the block- ing minority thresholds defined in the CACs. This implies that
the ECB Council

16
European Central Bank. (2015). Decision (EU) 2015/774 of the European central bank of 4 March 2015 on a secondary markets
public sector asset purchase programme (ECB/2015/10).
17
Howarth, D., & Quaglia, L. (2014). The steep road to European banking union: Constructing the single
resolution mechanism. Journal of Common Market Studies, 52, 125–140.
18
Vaubel, R. (1994). The public choice analysis of European integration: A survey. European Journal of
Political Economy, 10(1), 227–249.
will have a veto power in future bondholder votes, which makes a CAC-based debt restructuring highly unlikely.
Also the financing of the EU corona recovery plan can be interpreted as a move towards a transfer solution. From the 750
billion euro package, 390 billion euros are paid out as non-refundable grants and 360 billion euros as loans. This 750 billion
euro package is fully debt-financed through the issuance of EU bonds guaranteed by the EU budget. However, the EU
capacity to repay the debt is ultimately secured through increased EU claims to Member State contributions. The duration
of this financial operation is very long with the repayment of maturing bonds dragging on until the year 2058. According to the
binding international treaty on the EU own resource system, a long-lasting joint liability for the corona debt was agreed:
Whenever in the coming four decades one Member State defaults on its European financial obligation or it leaves the EU
without a financial deal, its share will be distributed across the remaining solvent EU countries. Hence, the refinancing scheme
for the corona debt previews additional transfers from other countries as a solution whenever a country is unable to pay. All
these liability and transfer implications have almost fully escaped the public perception due to the complexity of the
institutional design. It might be too early to finally judge, whether these decisions only reflect the exceptional circum- stances
of the pandemic or whether they signal a permanent course. However, deci- sions taken in the pandemic crisis are precedents
for new crises. These precedents are fully in line with the expectation that hidden transfers are the most plausible European
answer to future insolvencies of euro area Member States.