VIPS – Proposal for a Viable Insolvency Procedure for Sovereign States in the Eurozone
ResearchThe government debt crisis unleashed a wave of reforms in 2010 – some of which were implemented in an overly hasty manner – to stabilise the euro and the heavily indebted European countries. Even though the eurozone's institutional framework and its capacity to respond to crises have been improved significantly, the architecture of the euro area remains vulnerable in one respect: the absence of a credible and well-defined debt restructuring mechanism in the event of a nation's insolvency, i.e. its loss of creditworthiness on the capital market. A recent study conducted by the Mannheim Centre for European Economic Research (ZEW) addresses this problem. The study conceives and depicts a Viable Insolvency Procedure for Sovereigns (VIPS) in the eurozone.
ZEW's VIPS concept is based on two pillars: first, a contractually binding insolvency regime for the euro area that re-establishes market discipline in the long term; second, a credible transition phase that runs until the insolvency regime enters into force. VIPS takes a cautious approach and avoids any sudden measures that could destabilise the still fragile situation in the eurozone. Instead, the VIPS proposal opts for a transition period before fully implementing a European debt restructuring mechanism. A credible debt restructuring mechanism would eliminate the expectation on the part of private creditors that eurozone member states would bail out highly indebted countries when required. It would also dispel uncertainty concerning the implementation and the outcomes of a restructuring of government debt.
ZEW proposes a debt restructuring mechanism that becomes effective after a transitional period once the criteria established in advance have been met, or at the latest at a clearly defined point of time in the future. It incorporates ideas put forward in earlier proposals, but with respect to a number of aspects, the VIPS mechanism is more specific and complements the previous proposals.
The insolvency procedure proposed by ZEW allows member states facing liquidity bottlenecks a discretionary decision whether to apply for support under a conditional European Stability Mechanism (ESM) programme. Creditors cannot oblige a country to accept liquidity support, let alone force them into debt restructuring. However, if the ESM programme fails to stabilise the country's debt capacity within a three-year shelter period, the country must negotiate debt restructuring measures with its creditors, including the ESM. These negotiations require clear-cut and enforceable regulations. During these negotiations, there is a strict debt moratorium that includes a stay on all repayments until the negotiations have ended. Compliance with the debt moratorium is monitored by the ESM and possibly by the ECB/European Commission/IMF troika in order to prevent any payments that would benefit only one group of creditors. For a similar reason, the VIPS concept also includes a eurozone-wide introduction of aggregated "Collective Action Clauses" giving a qualified majority of creditors the option to agree on a debt restructuring scheme that is legally binding for all creditors, including a minority that votes against the scheme. The minority would have no possibility to take court action in order to obtain repayment of the original amount of debt. The creditors' maximum loss given default is limited, since a potential haircut must not push a country's debt ratio below the Maastricht limit of 60 per cent of GDP.
Earlier proposals have barely touched on the problem that the implementation of a debt restructuring mechanism could result in further destabilisation of the economic situation against the backdrop of high government debt levels and fragile banks. VIPS therefore proposes a lagged implementation, which we call the VIPS bridge. The regulations for the debt restructuring mechanism discussed above should be set and adopted now. However, the new regime should not enter into force before pre-specified quantifiable criteria have been met, including a defined average debt-to-GDP ratio of eurozone member states. If these criteria cannot be met before a predetermined date (e.g. 2030), the regime should enter into force at the latest at that very date. This prevents further destabilisation in euro area government bond markets caused by the immediate introduction of the debt restructuring mechanism. Moreover, the still reform-friendly political decision-makers would commit themselves to a long-term procedure and to clear-cut criteria regarding its implementation.
For more information please contact
Prof. Dr. Clemens Fuest, E-Mail fuest@zew.de