How to resolve a systemic sovereign debt crisis
The recent Eurozone Crisis has kindled an animated debate on how to deal with the sovereign debt crisis of a systemic country. In particular, the Crisis has brought to the forefront the risk of a debt restructuring that imposes losses on private creditors – i.e. a bail-in – entailing large international spillovers. For example, in the case of Greece, Ireland, and Portugal, there were fears that a restructuring of sovereign bonds could have caused widespread financial turmoil by possibly destabilising the European banking sector and triggering runs on other sovereign debt markets (De Grauwe 2009, Wyplosz 2010).
The risk of international spillovers stemming from bail-ins is likely to reappear in future crises. As the world becomes more financially integrated and countries' balance sheets continue to grow, the potential for sovereign crises to destabilise the international community will remain a concrete possibility. This calls for policy action along two dimensions. First, it is crucial to put in place measures that can contain possible spillovers associated with bail-ins. These may include stronger prudential regulation, ample liquidity provision at times of crisis, or lighter forms of debt restructuring such as reprofiling (IMF 2015). The historical experience suggests that such measures can indeed be useful in containing spillovers. Second, should the above measures be unable to fully prevent spillovers, there is a need to carefully reconsider how the international community – and in particular those international financial institutions that are tasked to resolve sovereign debt crises – should intervene.
In a recent paper (Sandri 2015), I address the latter issue by developing a simple model that transparently characterises the trade-offs faced by international financial institutions in resolving a solvency debt crisis. Besides providing liquidity to the country by lending up to its future repayment capacity, international financial institutions face the difficult decision of how to address any remaining financing needs through a combination of three possible tools: fiscal consolidation by the country, a bail-in operation that involves the restructuring of sovereign debt held by private creditors, or official transfers from the international community (for example through the restructuring of debt held by the official sector or concessional financing). I use the model to solve for the policy mix that maximises the overall welfare of the crisis country and the international community.
Fiscal consolidation, bail-ins, or official transfers?
In the absence of spillovers, I show that international financial institutions should use only fiscal consolidation and bail-ins by choosing the combination that minimises the ex- costs of the crisis, without worrying about the ex ante effects on countries' behaviour. This is because – to the extent that creditors price at the margin the expected losses from debt restructuring into higher ex ante borrowing costs – bail-ins do not generate moral hazard. Imprudent behaviour by a country that increases the likelihood of a future debt restructuring is penalised through an increase in sovereign spreads. Official transfers should instead be avoided because they do generate moral hazard since they are not priced into sovereign borrowing costs.
Dealing with systemic countries – for which bail-ins impose negative externalities on the international community – raises significant new challenges. A first implication is that bail-ins should be used to a lesser extent since they are more socially harmful due to the associated spillovers. The key question is then how to compensate the reduction in bail-ins. If official transfers are ruled out, this has to be done entirely through an increase in fiscal consolidation. In this case, systemic countries might be required to endure an excessive amount of consolidation to spare the international community from the systemic consequences of bail-ins.
To avoid placing undue burden on the crisis country, it may thus become efficient to compensate the reduction in bail-ins not only through greater fiscal consolidation, but also with official transfers. In doing so, it is crucial to consider that transfers generate moral hazard since the costs sustained by the international community are not priced into sovereign spreads. In particular, the expectation of transfers induces countries to behave ex ante less prudently than is socially optimal. This raises a time-consistency problem for international financial institutions that would want to pledge ex ante not to provide transfers mobilised from the official sector, but actually use them ex post. Therefore, the social benefits from transfers crucially depend on the extent to which international financial institutions can operate under commitment by following a predetermined crisis-resolution framework.
If international financial institutions are not constrained by a predetermined crisis-resolution framework, they would exclusively focus on minimising the ex post costs of a crisis, neglecting the ex ante moral hazard consequences. International financial institutions would thus use official transfers to avoid any bail-ins whenever they entail spillovers. The resulting severe moral hazard effects could greatly reduce social welfare, possibly leading to an inferior outcome than if international financial institutions did not intervene at all.
If instead international financial institutions operate under a predetermined framework, official transfers can improve social welfare. In this case, international financial institutions should use official transfers to optimally balance the desire to reduce the ex post costs of the crisis with the need to limit ex ante moral hazard. This tension closely captures the animated debate about the EZ debt crisis, where some commentators have emphasized the ex post costs of fiscal consolidation and the need for debt relief (Portes 2011, Wyplosz 2013), while others have pointed out the moral hazard consequences of concessional financing (Sinn 2011).
The optimal framework under commitment is illustrated in Figure 1. The horizontal and vertical axes show respectively the strength of spillovers from bail-ins and the country’s financing needs. International financial institutions should lend to the country at actuarially fair rates up to its borrowing capacity. To cover the remaining financing needs, we observe that as spillovers become stronger, it is efficient to reduce the size of bail-ins and increase the amount of fiscal consolidation. However, if spillovers are sufficiently large – so that the marginal cost of fiscal consolidation reaches the moral hazard cost from transfers – it becomes efficient to provide the country with official transfers in order to avoid excessive fiscal consolidation.
Welfare implications for the crisis country
One concern with the crisis-resolution framework in Figure 1 is that, by tailoring policy responses on the strength of spillovers, it may generate differences in welfare between more and less systemic countries and thus raise political objections. To explore this issue, Figure 2 illustrates the welfare implications for the country confronting a sovereign debt crisis.
The crisis country benefits the most if international financial institutions can secure and provide official transfers, but have no commitment. In this case, as explained before, international financial institutions would compensate any reduction in bail-ins through official transfers, without requiring any additional fiscal consolidation. This would come at the costs of large transfers financed by the international community and pervasive moral hazard. In contrast, the country’s welfare is lowest if international financial institutions are unable to provide transfers, in which case any reduction in bail-ins has to be compensated with greater fiscal consolidation.
If instead international financial institutions can use official transfers under commitment as in Figure 1, the welfare implications for the crisis country are ambiguous. More systemic countries have to endure greater fiscal consolidation, but they also benefit from official transfers. The overall effects may thus be relatively balanced, avoiding substantive differences in welfare between more and less systemic countries.
To the extent that differences remain, it is important to realise that imposing a unique crisis-resolution framework irrespective of spillovers is not socially efficient. A more effective response could be to design a system of ex ante taxes and subsidies across countries to further equalise welfare. For example, to the extent that systemic countries are better off, they could be asked to contribute ex ante to a pool of funds that will be later used to finance transfers.
To minimise the overall costs associated with the solvency crisis of a systemic country, international financial institutions should tailor their crisis response depending on the strength of spillovers arising from bail-ins. In particular, larger spillovers that cannot be contained through defensive policy measures call for smaller bail-ins and somewhat larger fiscal consolidation. Furthermore, to avoid excessive fiscal consolidation, highly systemic countries should receive official transfers from the international community. To contain the moral hazard implications of transfers, it is important that international financial institutions operate under a predetermined crisis-resolution framework that ensures that transfers are used only in exceptional circumstances when spillovers are particularly severe.
De Grauwe, P (2009), “ Greece: The Start of a Systemic Crisis of the Eurozone? ”, VoxEU, 15 December.
International Monetary Fund (2015), “The Fund’s Lending Framework and Sovereign Debt – Further Considerations,” Staff Report for the Executive Board.
Manasse , P (2011), “ Greece, the unbearable heaviness of debt ”, VoxEU, 24 May.
Portes, R (2011), “ Restructure Ireland’s debt ”, VoxEU, 26 April.
Sandri, D (2015), “Dealing with Systemic Sovereign Debt Crises: Fiscal Consolidation, Bail-ins or Official Transfers?” IMF Working Paper No. 15/233.
Sinn, H-W (2011), “ How to rescue the euro: Ten commandments ”, 3 October.
Wyplosz, C (2010), “ The Eurozone slides into a vicious cycle ”, VoxEU, 3 December.
Wyplosz, C (2012), “ Fiscal discipline in the monetary union ”, VoxEU, 26 November.
Wyplosz, C (2013), “ Messing up the next Greek debt relief could endanger the Eurozone ”, VoxEU, 23 September.
SOURCE: World Economic Forum