Europe’s pain must be widely shared
Raghuram Rajan
December 6, 2011
Permalink
Any proposed resolution to the European crisis over the next few days will have to be economically viable as well as politically palatable to both the rescuers and the rescued if it is to restore confidence to the sovereign bond markets. This means paying attention not just to the technical details but also to how it is presented.
There is growing consensus about the key elements of any resolution. Italy and Spain will have to come up with credible medium term programmes that will not just boost their fiscal health, but also improve their ability to grow their way out of trouble.
While any plan will involve pain for the citizenry, the markets must also deem the pain politically tolerable, at least relative to the alternatives. It is important that the plan be seen as domestically devised, although voters will have no illusions about the external and market pressures that have forced action. At the same time, the plan’s credibility could be bolstered by an external agency, such as the International Monetary Fund, if it evaluates the plan for consistency with the country’s goals, and monitors implementation.
Some institution – either the IMF or the European Financial Stability Facility with funding from countries or the European Central Bank – has to stand ready to fund borrowing by Italy, Spain, and any other potentially distressed countries over the next year or two. There is an important detail here which has largely been papered over in public discussions. If this funding is senior and therefore higher priority to private debt – as IMF funding typically is – it will be harder for these countries to regain access to markets. For the more a country borrows in the short term from official sources, the further back in line it will push private creditors, making them susceptible to larger haircuts if the country eventually does default.
Private markets need to be convinced both that there is a low probability of default and that there is some additional loss-bearing capacity in the new funding so that outstanding or rolled over private debt does not have to bear the entire loss if there is a default. This may seem unfair. After all, why should the taxpayer accept a loss when they are saving the private sector’s bacon by providing new funding?
In the best of worlds, distressed countries would default as soon as private markets stopped funding them, and they would impose the losses on private bondholders. In the world we live in though, if the view is that Italy and Spain are solvent, or are too big to fail, then official funding should be structured so that it gives these countries their best chance.
..
Does this mean that official funding should be junior to private debt in a restructuring? Probably not, for that will require substantially more loss-bearing capacity from the official sector for any given amount of funding – capacity that is probably not available. Of greater public concern, official funding, if junior, will then be providing a greater cushion to private creditors and thus bailing them out to an even greater extent.
..
The simplest solution is that official funding should be treated no different from private debt – best achieved if official sources buy country bonds as they are issued (possibly at a predetermined yield) and agree to be treated on par with private creditors in a restructuring. As the country regains market confidence, the official funding can be reduced, and eventually the bonds sold back to the markets.
The key point is that official funding must be have loss-bearing capacity. If the IMF is the organisation through which funding is channelled to the countries, and if its funding is to be treated on par with private debt, it will need a guarantee from the EFSF, or the eurozone that it will be indemnified in any restructuring. Of course, the community of nations that compose the IMF may be willing to accept some burden sharing once a sufficient buffer provided by the eurozone is eaten through, but that cannot be taken for granted.
If the first two elements of the plan are in place, there should be little need for the third – an ECB willing to buy bonds in the secondary market in order to narrow spreads, and provide further confidence. Indeed, if the ECB intends to claim priority status for any bonds it buys, it is probably best that it buy very little. Of course, the ECB will have to continue to provide support to banks until confidence about their holdings returns.
There is, however, one more element that is needed to assure markets that the resolution is politically viable. Citizens across Europe, whether in rescued countries or rescuing countries, will be paying for years for a mess that no one feels they are responsible for. Banks may not all have voluntarily loaded up on distressed government bonds – some were pressured by supervisors, others by governments – but many have made unwise bets. If they are seen as profiting unduly from the rescue, even as they return to their bad old ways of paying for non-performance, they will undermine political support for the rescue, and perhaps even for capitalism.
So a final element of the package ought to be a monitored pledge by the banks in the eurozone that they will not unload bonds as the official sector steps in, that they will be circumspect about bonuses till economies start growing strongly again and that they will raise capital over time instead of continuing to deleverage – if this hurts equity holders, they should think of this as burden sharing. Cries that this is not capitalism should be met with the retort: “neither are bail-outs!”.
The writer is professor of finance at the University of Chicago’s Booth School
Any proposed resolution to the European crisis over the next few days will have to be economically viable as well as politically palatable to both the rescuers and the rescued if it is to restore confidence to the sovereign bond markets. This means paying attention not just to the technical details but also to how it is presented.
There is growing consensus about the key elements of any resolution. Italy and Spain will have to come up with credible medium term programmes that will not just boost their fiscal health, but also improve their ability to grow their way out of trouble.
While any plan will involve pain for the citizenry, the markets must also deem the pain politically tolerable, at least relative to the alternatives. It is important that the plan be seen as domestically devised, although voters will have no illusions about the external and market pressures that have forced action. At the same time, the plan’s credibility could be bolstered by an external agency, such as the International Monetary Fund, if it evaluates the plan for consistency with the country’s goals, and monitors implementation.
Some institution – either the IMF or the European Financial Stability Facility with funding from countries or the European Central Bank – has to stand ready to fund borrowing by Italy, Spain, and any other potentially distressed countries over the next year or two. There is an important detail here which has largely been papered over in public discussions. If this funding is senior and therefore higher priority to private debt – as IMF funding typically is – it will be harder for these countries to regain access to markets. For the more a country borrows in the short term from official sources, the further back in line it will push private creditors, making them susceptible to larger haircuts if the country eventually does default.
Private markets need to be convinced both that there is a low probability of default and that there is some additional loss-bearing capacity in the new funding so that outstanding or rolled over private debt does not have to bear the entire loss if there is a default. This may seem unfair. After all, why should the taxpayer accept a loss when they are saving the private sector’s bacon by providing new funding?
In the best of worlds, distressed countries would default as soon as private markets stopped funding them, and they would impose the losses on private bondholders. In the world we live in though, if the view is that Italy and Spain are solvent, or are too big to fail, then official funding should be structured so that it gives these countries their best chance.
..
Does this mean that official funding should be junior to private debt in a restructuring? Probably not, for that will require substantially more loss-bearing capacity from the official sector for any given amount of funding – capacity that is probably not available. Of greater public concern, official funding, if junior, will then be providing a greater cushion to private creditors and thus bailing them out to an even greater extent.
..
The simplest solution is that official funding should be treated no different from private debt – best achieved if official sources buy country bonds as they are issued (possibly at a predetermined yield) and agree to be treated on par with private creditors in a restructuring. As the country regains market confidence, the official funding can be reduced, and eventually the bonds sold back to the markets.
The key point is that official funding must be have loss-bearing capacity. If the IMF is the organisation through which funding is channelled to the countries, and if its funding is to be treated on par with private debt, it will need a guarantee from the EFSF, or the eurozone that it will be indemnified in any restructuring. Of course, the community of nations that compose the IMF may be willing to accept some burden sharing once a sufficient buffer provided by the eurozone is eaten through, but that cannot be taken for granted.
If the first two elements of the plan are in place, there should be little need for the third – an ECB willing to buy bonds in the secondary market in order to narrow spreads, and provide further confidence. Indeed, if the ECB intends to claim priority status for any bonds it buys, it is probably best that it buy very little. Of course, the ECB will have to continue to provide support to banks until confidence about their holdings returns.
There is, however, one more element that is needed to assure markets that the resolution is politically viable. Citizens across Europe, whether in rescued countries or rescuing countries, will be paying for years for a mess that no one feels they are responsible for. Banks may not all have voluntarily loaded up on distressed government bonds – some were pressured by supervisors, others by governments – but many have made unwise bets. If they are seen as profiting unduly from the rescue, even as they return to their bad old ways of paying for non-performance, they will undermine political support for the rescue, and perhaps even for capitalism.
So a final element of the package ought to be a monitored pledge by the banks in the eurozone that they will not unload bonds as the official sector steps in, that they will be circumspect about bonuses till economies start growing strongly again and that they will raise capital over time instead of continuing to deleverage – if this hurts equity holders, they should think of this as burden sharing. Cries that this is not capitalism should be met with the retort: “neither are bail-outs!”.
The writer is professor of finance at the University of Chicago’s Booth School
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