World Economy

Euro zone fears for bailout if Fed hikes rates

Nasos Koukakis, special to
A board displays the exchange rate for peso and U.S. dollars at a foreign-exchange house in Mexico City, August 20, 2015.
Edgard Garrido | Reuters

The eyes of the international economic community are sharply focused on the Fed's monetary policy decision to raise dollar interest rates today, since any uptick could affect international fixed-income yields and spreads in the bond market. That could seriously hurt euro zone bailout programs that involve sovereign debt restructuring.

Indeed, the U.S. rate hike creates competition for non-U.S. dollar bond issues pushing the required yields higher, thus damaging the low-yield environment created by European Central Bank's (ECB) quantitative easing (QE) policy earlier in the year. Apparently, euro zone sovereign yields have already anticipated all this and climbed much higher than the March-April lows.

The German 10-year bund yield scores 0.78 percent vs. 0.079 percent just five months ago. European Union periphery yields have been affected as well. Italy's comparable trades at 1.91 percent, Spain's at 2.12 percent and Portugal's at 2.62 percent, up from 1.25 percent, 1.23 percent and 1.70 percent, respectively, according to Bloomberg.

And here comes the catch: The rise in European yields "nullifies" the effect of the QE policy set out this year and causes serious repercussions to the plans regarding the new policy proposals vis-à-vis future bailout programs and overall sovereign debt restructuring.

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According to reports from last Friday's informal European finance ministers meeting in Luxembourg, Germany's Finance Minister Wolfgang Schäuble presented his counterparts with a proposal aimed at weakening the rights of investors in euro zone government bonds so that they shoulder the burden of restructuring the debt of over-indebted sovereign states.

Germany also suggested the further streamlining of the collective-action clauses included in euro zone government bonds, to make it easier to force private creditors into accepting debt restructuring. Germany also wants to force holders of sovereign bonds to accept an automatic extension of maturities whenever a financially distressed euro zone member seeks help from the European Stability Mechanism (ESM) bailout fund.

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This is not a new proposal. The first time it was publicized, it caused great turbulence in the European bond market. It was October 18, 2010, when Angela Merkel and Nicolas Sarkozy agreed that private creditors would suffer the losses in any future sovereign bailouts from the ESM. This agreement led to an increase in sovereign spreads in late 2010 and early 2011.

The Deauville Declaration created quite a flurry around Europe at the time; Irish and Portuguese bond yields skyrocketed, resulting in the bailouts, while the banking problems in countries such as Spain worsened.

However, Schäuble's new proposal for a pan–European sovereign debt restructuring procedure had built on Deauville decisions. Germany claims that the existing ambivalence toward debt restructuring and the risk treatment of sovereign debt leads to policies that increase the moral hazard and risk for future instability. So they suggest a very advanced process for automatic debt haircuts, as well as a process outside the existing legal framework to act as a shield for private bondholders.

"It should result in a sound debt restructuring mechanism that would resolve the current problems in the market, especially with holdout funds," Professor Emilios Avgouleas from the University of Edinburgh told CNBC.

According to Avgouleas—who was actively involved in the Greek debt restructuring of 2012—this must be quite an intractable dilemma, as the new initiative seems to be designed to pave the way for restructuring the Greek debt in the next few months, and thus they might wish that the new regime also has an ex-post effect.

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But the German initiative did not appear out of thin air. Last October the International Monetary Fund's executive board supported reforms in international sovereign bond contracts designed to address the collective-action problems in sovereign debt restructurings. The IMF recognized that in cases where a sovereign and its creditors have concluded that debt restructuring is necessary, the existing legal framework may not be sufficient to prevent "holdout" creditors from undermining the restructuring process.

Existing clauses generally require a vote to take place on a per-series basis—that is, bond issuance by bond issuance. As a result, it is possible for holdout creditors to obtain a sufficiently large share of bonds in a particular issuance, thereby blocking the operation of the collective-action clause, and therefore the restructuring of that issuance. In general, the uncertainty generated by collective-action problems can create delays in the restructuring process to the detriment of the debtor, creditors and the system in general. This became very apparent in recent months with the Argentine litigation in the United States.

The IMF's Executive Board endorsed the introduction of a new voting procedure that allows decisions to be taken by a majority of creditors across all bond issuance's, without the need for an issuance-by-issuance vote. As it appears, the new Schäuble proposal fully adopts the IMF's recommendations.

"That's a great idea in order to eliminate the room of holdouts to oppose restructurings or claim full payment for paper that they have normally bought at discount," Avgouleas said, adding that "on the other hand, it would be deeply unsatisfactory if it is limited only to private-sector creditors.

"The collective-action clauses changes should also extend to bonds held by public-sector creditors such as central banks if they do not wish to enter the restructuring process voluntarily. Characteristic example here is the behavior of the ECB, which claimed full payment of the Greek bonds it has held, forcing an exclusion of its holdings from the 2012 restructuring of the privately held Greek debt," the University of Edinburgh professor said.

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When Greece restructured its private-sector debt in 2012, it included the proposed collective-action clauses rules that limit the opportunity for a minority of investors to hold out from any new renegotiation in a quest for better terms. This only applied to private investors. For now the long-standing assumption is that Greece will not impose more losses on private bondholders, because these government bonds amount to only 43 billion of the total 353-billion-euro debt.

It remains unknown whether or not sovereign issuers and market participants would be willing to voluntarily exchange their existing bonds for new bonds that don't have these problematic collective-action clauses.

"'In principle, this can only work for new debt rather than legacy debt. If the euro zone tries to insert such clauses to legacy debt, I can imagine that giving rise to a wave of litigation by opposing funds and banks who hold euro area debt," Avgouleas said.

Under these circumstances, the risk of fragmentation in the bond markets is likely, with burden falling on the bonds of heavily indebted euro zone countries, which are either in need of a bailout rescue or will soon find themselves in such a position.

"In the current conditions of excessive liquidity, low interest rates and ECB's QE, and with the ECB power to trigger Outright Monetary Transactions still on the cards, it is unlikely that the cost of refinancing the debt of the countries in the European periphery will experience a substantial rise in the short term. But in the medium term, yields will rise and they will rise substantially, increasing the fiscal burden of over-indebted countries in the euro area periphery," Professor Avgouleas said.

Given the forthcoming increase in the Fed's interest rates and subsequent rise in dollar-denominated yields, investors are expected to look for better returns. In such an environment, the countries of the European periphery facing indebtedness problems or attempting to exit bailout programs will be required to offer higher incentives for their investors and cover any potential risk premium.

Borrowing costs may increase further. Market analysts are concerned about what lies ahead once the ECB starts raising its interest rates and borrowing costs in indebted countries rise. From this perspective, the ghost of Deauville haunts euro zone sovereign debt once more.

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—By Nasos Koukakis, special to