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CAN A EUROPEAN
SDRM BE EFFECTIVE?
ISTITUTO AFFARI INTERNAZIONALI
“Sovereign Debt Crises: Prevention and Management”
10th December 2018 – Rome
Marco Committeri and Pietro Tommasino
Bank of Italy

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Contents
1. A simple framework for policy discussions
2. Earlier debates
3. Preliminary comments
4. The Euro area: still a work in progress
5. Would the SDRM help?
6. A possible way forward?

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A simple framework for policy discussions
For an SDR to be viable and desirable from a collective welfare
perspective, its expected cost C must fall within a certain interval
CL < C < CU
• SDRs should “ideally” be costly enough to incentivize the debtors to honor their
financial obligations,
• but also not so expensive as to kill countries’ ability to repay their creditors.
• And surely not too costly from the point of view of the broader economic and
financial system, if one wants to preserve the very credibility of the SDR.
• Sovereign debt crises should always be addressed in a holistic manner, taking
account their multi-faceted dimensions: prevention, management, and resolution.

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Earlier debates: cold facts (1)
• Historically, SDR debates have centered on those factors that push C above its
socially desirable upper level CU:
• Late 1990s / early 2000s  «bonded finance» and disruptive litigation risks for
EMEs
• Today  SDRs in highly integrated areas; systemic risks; focus on preventive
rules to solicit (or to force) greater market discipline
• In the early 2000s the international community seemed confident to have devised a
reasonably robust framework (if not a mechanism) for addressing sovereign debt
crises. The framework included:
• clearer (and hopefully credible) rules for IMF lending (ability to say “no”)
• more predictable SDR processes (to contain SDR cost).
• The framework was not supposed to work in any mechanical manner, as there were
ample margins of maneuver for both the IMF and private creditors.

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Earlier debates: cold facts (2)
SDR processes
• The “contractual” approach (based on CACs) prevailed over the “statutory”
mechanism proposed by Mrs. Krueger, which was definitely dismissed by the IMFC in
April 2003
• The contractual approach has evolved further in the first half of this decade:
• Two new standards for aggregating creditors’ claims during an SDR (the “Euro
Area Model CAC 2012” and the 2014 “ICMA Model Clauses”)
• New language for the “pari passu” clause
• Discussions on new “state-contingent” debt instruments for sovereigns
(including equity-like contracts such as GDP-indexed bonds).

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Earlier debates: cold facts (3)
IMF lending rules (EAP, Exceptional access policy)
• These rules were developed in the early 2000s (EAP “in capital account crises”) and perfected
in 2009 (EAP for all types of BOP needs, including potential ones)
• The rules were changed in 2010 with the Greek crisis, to allow Fund financing in cases of
dubious sustainability but elevated risks of systemic disruptions (so-called “systemic
exemption”).
• They were changed again in 2016, after systemic risks in the euro area had receded.
• Systemic exemption repealed
• When debt sustainability is uncertain, Fund resources should be combined with an SDR
or with additional external financing from other creditors (official or private).
• The current EAP is yet to be tested.

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Earlier debates: comments (1)
Key targets of these proposals
• SDR costs associated to litigation risks and lack of creditor coordination.
• Sovereign debt owed to private creditors (PSI), not official ones (OSI).
• Sovereign bonds issued internationally (either governed by foreign law or
subject to the jurisdiction of foreign courts) – THEREFORE, main focus was
on Emerging market countries, not advanced ones.
Litigation/creditor coordination problems: How relevant in practice?
• Evidence with SDRs in EMEs is mixed: “barking up the wrong tree?”
• What are the expected gains for Advanced countries? (Most of their debt is issued
domestically, and this can in principle be restructured either coercively or via
moral suasion e.g. Greece 2012)

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Earlier debates: comments (2)
“Enhanced” CACs represent today the prevailing contractual standard in the euro
area sovereign debt market. The choice of these contractual tools has two main
implications:
• First, they are a means for reassuring private investors that sovereigns will abide by
their own obligations and will not abuse their discretionary powers (no repetition of
Greece 2012)
• Second, it will become more and more difficult to administer PSI without having some
OSI. In particular, there will be no preferential treatment for official creditors (including
central banks) that are in the same voting pool as private ones.
Why severing the bank-sovereign nexus was left out of the international agenda
in those early years?
• The nexus in question is multifaceted and hard to understand fully.
• Major advanced countries were not prepared to go along that route.
• Reducing “too much” the cost of sovereign debt crises could have been
counterproductive.

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The Euro Area: still a work in progress
• Two ways to attain fiscal discipline: rules vs markets
• When the Euro was designed, the framers made a clear choice in favor of the former.
• The rationale was clearly stated in the 1989 Delors report: “Experience suggests that market
perceptions do not necessarily provide strong and compelling signals and that access to a
large capital market may for some time even facilitate the financing of economic imbalances.
Rather than leading to a gradual adaptation of borrowing costs, market views about the
creditworthiness of official borrowers tend to change abruptly and result in the closure of
access to market financing. The constraints imposed by market forces might either be
too slow and weak or too sudden and disruptive”
• By and large, the evidence vindicates Delors’ skepticism (see e.g. Giordano et al. 2013,
Favero and Missale, 2012).

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Would the SDRM help?
EX ANTE
• An SDRM (if credible!) reduces investors’ uncertainty about when and if a default
happens. Therefore, it should be easier for markets to compute sovereign risk as
a function of fundamentals. To the extent that this is priced in sovereign yields, this
could improve fiscal discipline.
EX POST
• In case a country becomes nonetheless insolvent, an SDRM would limit socially
costly behaviour: debtors’ “gambling for resurrection”, creditors’ “hold-out”.
• It could reduce the bargaining power of the debtor country. It is argued that,
without an SDRM, in Europe debtors would always have the upper hand, obtaining a
bail-out at the expense of other countries, due to the size of the cross-country spillovers
and the risk of contagion. Gros and Meyer (2010): “debtors’ main negotiating asset is
the threat of a disorderly default”.

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Would the SDRM help?
Not surprisingly, the “old” global debate about the desirability of a statutory
approach resurfaced in post-crisis Europe
Gianviti et al. (2010):
• a procedure to initiate and conduct negotiations between a sovereign debtor with
unsustainable debt and its creditors.
• Three new institutions: a legal one in charge of adjudication, an economic one to
provide economic expertise and judgement, and a financial one for financial
assistance.
• The debt-restructuring procedure would be opened by the legal body upon the
request of a borrower and upon approval by the economic body.
• Elements of this proposal later included in the ESM treaty (ESM performs most of
the tasks assigned to the economic and the financial body).

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Would the SDRM help?
Gianviti et al. (2010) do not establish ex ante what will be the outcome of each step,
leaving space to judgment.
Later proposals introduce much more automaticity, with the idea (presumably) to further
reduce ex post debtor moral hazard
Weber, Ulbrich and Wendorff (2010), Bundesbank (2016):
• Three years’ debt reprofiling upon request of assistance. Without even trying to
distinguish between illiquidity and insolvency. It would imply a significant reduction
in the financial and policy role of ESM
Buchheit et al. (2013), Corsetti et al. (2015), Andritsky et al. (2016)
• No automatic re-profiling, but simple numerical criteria to distinguish between
illiquidity and insolvency.

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Would the SDRM help?
Bénassy-Quéré et al. (2018) (as clarified by Pisany-Ferry and Zettelmeyer 2018)
• ESM criteria for deciding when a sovereign is insolvent “must be transparent and
consistent across countries”
• Also, the sustainability assessment needs to be based “on a data-driven method
that can be reproduced and checked by the public”…
• … but the authors stop short of spelling out a set of numerical
triggers/thresholds.

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Would the SDRM help?
A taxonomy
Source: Committeri and Tommasino (2018)

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Would the SDRM help?
While automaticity has its advantages, it also comes with significant risks.
• An element of judgment seems needed to assess a country’s debt sustainability
• Countries with high legacy debts, whose public finances are nonetheless
sustainable, would face the risk of self-fulfilling crises (Calvo, 1988; Cole and
Kehoe, 2000).

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Would the SDRM help?
Debt/GDP
Probability
of default
Good equilibrium
Bad equilibrium
dlow dhigh

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A possible way forward?
• A two-pronged strategy (Fuerst et al., 2016; Corsetti et al., 2015, Cioffi et al.,
forthcoming)
a) First, reduce all national public debts below the multiple equilibrium threshold,
gradually (Fuerst et al., 2016) or implementing a one-off “redemption” (Corsetti et
al., 2015, Cioffi et al., forthcoming).
b) Afterwards, a non-automatic form of SDR framework (not a mechanism) can be
introduced.
• If properly designed the package could represent a Pareto improvement (see e.g.
Tirole, 2015; Basu and Stiglitz, 2015).

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A possible way forward?
• A one-off operation, similar to the one proposed by German Council of Economic Experts
(2011): a financial vehicle (European redemption fund) redeems a fraction of the national
debts (e.g. 60% of each country’s GDP). In exchange, countries would transfer yearly a
sufficient fraction of their seigniorage and/or tax revenues to the vehicle.
• Temporary and “passive” in nature: the only activity of the fund would be to pay interest on
its debt and gradually redeem it. No other expenditure may be financed. Not an instrument to
sustain investment (≠from EC’s EISF) or to implement counter-cyclical policies (≠ from
Eurobonds etc.)
• Transfers should be country-specific and reflect the fundamental riskiness of each
country’s public debt (e.g. de Grauwe and Mosen, 2009). This could made the scheme
politically acceptable for the more creditworthy countries.
• Not a panacea, but if high-debt countries engage in a serious fiscal consolidation, the
fund would shield them from the vagaries of financial markets, increasing the probability
of success of their debt-reduction strategy.

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Thank you for your attention!