Creating Order in the Euro Zone: Merkel's Rules for Bankruptcy

By Christian Reiermann

Fearing a lasting burden on taxpayers, the German government is preparing a set of insolvency rules for countries in the euro zone. It would require private investors to bear some of the financial burden and force the affected countries to give up some sovereignty. The plan is guaranteed to meet with resistance.

Photo Gallery: Insolvency Rules for the Euro Zone Photos
REUTERS

As a physicist and an avowed admirer of the Swabian housewife, German Chancellor Angela Merkel, leader of the center-right Christian Democrats (CDU), is seeking to establish binding rules in the midst of the chaos of financial and monetary crises. Her desire for order was reinforced recently when the prospect of Greece collapsing under a mountain of debt triggered turmoil in the European Monetary Union.

The first national bankruptcy on European soil in decades was only prevented because the remaining countries in the euro zone came to the aid of their faltering fellow member with billions in loans and loan guarantees. The chancellor, determined not to allow the Greek debacle to be repeated elsewhere, proposed the establishment of a procedure to ensure "orderly national bankruptcies." The German chancellor hoped that the plan would create "an important incentive for the euro-zone members to keep their budgets under control."

Finance Minister Wolfgang Schäuble, in complete agreement with Merkel, said: "We have to think about how, in an extreme situation, member states could become insolvent in an orderly fashion without threatening the euro zone as a whole."

Averting Future Problems

The two politicians have taken on a formidable task. They sense that the future of the euro is anything but certain, despite the recently approved €750 billion ($945 billion) European rescue package. In approving the emergency measure, all of those involved, including Merkel, French President Nicolas Sarkozy, European Commission President José Manuel Barroso and Greek Prime Minister Georgios Papandreou, are merely buying time, which they must utilize to work off deficits. This is especially true when it comes to Greece, which will have to restructure its budget by the time all of the bailout packages expire in 2013, but even more so for the euro zone as a whole.

To avert future problems, the Germans have asked their experts to assemble a package of reforms that could stabilize the construct of the European Monetary Union in important ways -- if, that is, the partner countries play along. And even then, it cannot be ruled out that some countries could go bankrupt in the future.

The effort is necessary, because important safety measures to protect the common currency are not working. The Stability and Growth Pact, which was intended to nip excessive government borrowing in the bud, proved to be largely worthless. Some of the monetary union's ironclad principles were ignored, including a rule that prohibits member states from coming to the aid of others in financial difficulties. It was only with political tricks of questionable legitimacy that the euro-zone countries managed to ward off the crisis in the short term, but by no means has it been overcome. German taxpayers, in particular, could face enormous burdens if the current measures fail. Under the provisions of the bailout package, Germany has pledged up to €170 billion.

With her plans for orderly national bankruptcies, Merkel intends to eliminate these vulnerabilities within the monetary union. She hopes to install a procedure under which a bankrupt country could be restructured in the future. She also wants to prevent the rescue program from becoming a permanent fixture in the future and, as a result, a chronic threat to the German federal budget.

Sharing the Burden

Despite the urgency of the problem, the German government must take a cautious approach. The chancellor is worried that her deliberations could be seen as a vote of no confidence in the European bailout package, which is why she is treating the plans with such secrecy. Less than a dozen experts from various parts of the government are even familiar with the matter.

Her goal is to structure the plans as a further development of, rather than an alternative to the bailout package. Work on the project has already made a lot of progress. A concept based on preliminary work carried out by the Finance and Justice Ministries is already being circulated at the Chancellery.

If the plans are implemented, banks and investors will not be the only ones bearing the burden when countries in the euro zone encounter financial difficulties. The debt-ridden countries themselves will also have to make substantial sacrifices, and their governments will cede some of their power. The experts propose a two-step procedure. In describing the goals of this approach, Schäuble says: "Whenever a company files for bankruptcy, the creditors must relinquish a portion of their claims. The same should apply in cases of national bankruptcy."

The reformers expect the plan to have a deterrent effect, both for lenders and borrowers. If banks and private investors must anticipate that they may not recoup all of their investment, they will be more cautious about lending money to certain countries.

Those countries, in turn, will be forced to preserve their credit ratings if they hope to continue borrowing. The goal of the German government experts developing the plan is to straighten out a situation gone haywire in the midst of enthusiasm over the bailout program. "The private sector should be involved in the procedure, so that taxpayers are not the only ones bearing the financial burdens," the plan reads. "The bondholder receives a risk premium through the coupon, so it should also have to bear this risk."

Aggravating the Crisis?

But is this feasible? In a situation in which a euro-zone country can no longer service its debts, the government experts propose a "tailored combination of maturity extension and a suitable reduction of the face value or interest rate" of the bonds in question. In other words, creditors receive less money than they are entitled to, and they have to wait longer for it, a process experts refer to as a "haircut."

The debtor country derives most of the benefit. Its financial burden declines, so that the government no longer has to incur new debts to pay off the old ones. This reduces the burden on government budgets, because the country can only borrow new funds by offering its lenders a higher risk premium. Because it blasts new holes into the government budget, this crisis surcharge can also aggravate the crisis.

But the creditors should also receive an incentive to accommodate a debtor nation. In return for waiving their claims, they are guaranteed a residual value of the bond, which would be no more than half its face value. The benefit to them is that they do not have to write off the entire bond. The debtor nation must pay a guarantee fee, which means that it also carries a portion of the burden.

Because less than half of debts are usually forgiven in a haircut procedure, the bankrupt countries are left with an "original country risk." This residual amount functions as a signal, because the country's own bonds are still being traded. If this credit rating declines interest rates rise, and if it rises interest rates decline. In other words, investors, governments and bailout organizations are consistently aware of the market's assessment of the situation.

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