Lorenzo Bini Smaghi: Private sector involvement - from (good) theory to
(bad) practice
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Reinventing Bretton Woods Committee, Berlin, 6 June 2011.
* * *
The title of this first session of the conference is: "Policy responses within countries and
inside the eurozone since 2010: an appraisal". The topic is very broad and I cannot cover it in
such a short time span unless I am selective and focus on some specific issues.
I would like to consider mainly what has not gone as expected and the disappointments. This
enables me to avoid talking, once again, about the ECB's actions over the last 18 months.
There are at least three things that have gone wrong. The first is that governments of the
countries under stress waited too long before recognising that they needed financial
assistance, and submitting their requests for support to the IMF and EU. This is true in all
three cases, Greece, Ireland and Portugal. More often than not support programmes are
delayed and within well integrated economic and financial regions such as the euro area
these delays exacerbate market turmoil and create contagion. There is thus an externality in
leaving it entirely to the country in question to turn to the IMF and EU for financial assistance.
However, experience has shown that when a country requests such assistance, the national
authorities tend to blame European institutions, including the ECB, for having pushed them to
do so. "Europe" thus becomes a scapegoat and this may fuel strong - although
unjustified - anti-European sentiment in the countries concerned. So governments have a
natural inclination not to request financial assistance at an early stage.
The second thing that has gone wrong has been the implementation of the Greek
programme of reforms. Reform fatigue set in at an early stage and it probably went unnoticed
for a while. Member States adopting IMF/EU programmes have to remain firmly committed to
very specific measures, which need to be acted upon from the outset. Monitoring has to be
strengthened.
I will not elaborate on these two first issues but - being here in Berlin today - I would like to
focus on the third issue which has not gone well, in my opinion, namely the whole discussion
about private sector involvement. The point I would like to make is that having the private
sector actively involved in preventing and resolving sovereign crises is a good idea.
However, the practical implementation of this idea is fraught with complications and, if done
unwisely, may actually be very damaging, and turn out to be more costly for taxpayers. The
events of recent months seem to confirm my views.
I would define private sector involvement (PSI), for the purpose of this discussion, as
intentional efforts and contributions, formal or informal, undertaken in a context of sovereign
financial distress. This support ranges from softer forms, such as preventive talks, to harder
2
forms, such as debt rescheduling, restructurings, reprofiling or even debt write-downs.1 In
the remainder of my talk, I will look mainly at the harder forms of PSI, often called debt
restructurings.
The basic rationale behind involving private creditors when a debtor is in distress is
straightforward and uncontroversial: creditors and investors should bear the consequences
of their decisions as fully as possible and should not rely on taxpayers' money to be bailed
out.3 The underlying reason has long existed: a bailout by taxpayers today may encourage
risky lending by private investors in the future.
In the corporate sector, it is actually commonplace to apply such principles. Under
bankruptcy laws or out-of-court settlement guidelines, such as the London Rules, the Jakarta
Initiatives or the Hong Kong Guidelines, when a corporate is facing financing difficulties, the
responsibility is passed to the debtor and creditors to arrange debt settlements among
themselves. Indebted companies can reorganise and restructure their operations to return to
profitability. In turn, creditors agree to reschedule loans or accept the conversion of debt into
equity.
While the basic principles of private creditor participation in resolving the debtor's dilemma
are uncontroversial, the application of these principles to sovereign debt is much more
complex. Debt workouts in the corporate and public sectors are quite different. First,
assessing the solvency of a country is different from that of a company. The former requires
not only an analysis of the cash flow, the balance sheet and the assets and liabilities but also
an evaluation of the political will to implement the measures needed to ensure that the
country remains solvent. The capacity to service debt requires both a willingness and an
ability to implement policies that will generate the necessary resources. To quote the
example of Greece: it has a gross debt of around €330 billion and marketable assets worth
up to €300 billion, so the country is solvent to the extent that it is willing to sell off some of
these assets. The same conclusion would be reached by looking at the measures required to
achieve a balanced budget, which largely consist of reversing the decisions taken over the
last ten years in respect of public sector wage rises, expenditure increases and the adoption
of standard structural reforms which would bring Greece in line with other euro area
countries. Just to give an example, if, over the last 10 years, Greek public sector wages had
gone up at the same pace as inflation, and public employment had not increased, in 2010 the
Greek budget deficit to GDP ratio would have been around 4 percentage points lower and
the debt to GDP ratio about 30% lower.4
The key question is whether the Greek government and the Greek people are willing to
implement these measures. The answer to this question largely depends on the alternative
scenario, which is a default or restructuring of the public debt. A rational analysis comparing
the economic, financial, social and political costs of implementing the needed adjustments,
including privatisation, and the costs of a default/restructuring would conclude that the former
costs are lower. A rational decision-maker would thus opt for the adjustment and, on that
basis, Greece should be considered solvent and should be asked to service its debts.
The second difference between debt workouts in the corporate and public sectors is that,
unlike a company, a sovereign cannot be liquidated. There are no insolvency laws or
bankruptcy forum to address sovereign solvency problems, and IMF attempts to do so during
the last decade failed, for several reasons. What is clear is that in the case of an insolvent
sovereign, further official finance can only be provided when that sovereign restructures its
debts and, at the same time, undertakes serious and credible domestic fiscal adjustment and
structural economic reforms.5
The third feature that generally sets sovereign and corporate debt workouts apart is the
externalities they may generate. A debt restructuring of a sovereign may have severe
implications, both for the debtor's and the creditor's economies.
Most of the experience in this area has involved less developed countries. In these cases
private sector involvement has largely been a concern for foreign creditors. Taxpayers in
creditor countries were affected, depending on the size of the exposure of their respective
financial system and on whether the soundness of that system was jeopardised. Measures
have been used in the past to try to reduce this impact, in particular through regulatory
forbearance. One example is the prudential measures which, during the 1980s, permitted US
banks to book Brady bonds at their nominal value.
Historical experience has also rejected the Panglossian view that there exists such a thing as
an orderly debt restructuring. While some restructurings have indeed been successful and
can arguably be said to have occurred in an orderly fashion, they were often on a small scale
and executed under specific circumstances. The most striking and oft-quoted case is
Uruguay. However, more often than not, restructurings have been disorderly, harmful and
fraught with difficulties. The average length of the negotiations is 21⁄2 years6 and it can vary
greatly. In some cases, negotiations have taken just a few months (for instance, Uruguay in
2003, Pakistan in 1999, Chile in 1990 and Romania in 1983); in other cases they have taken
many years (for instance, Vietnam from 1982 until 1998, Jordan from 1989 to 1993, Peru
from 1983 to 1997 and Argentina more recently). Empirical evidence also shows that private
investors are likely to penalise a country which has a history of restructuring and to demand
higher risk premia.7
When considering a euro area economy, the following points should be kept in mind. First,
the domestic financial market would be severely affected by a default/restructuring of the
public debt. Large losses would have to be accounted for, as no forbearance would be
possible, and recapitalisation of the domestic banking system would require additional public
money. Second, given the role of the state as implicit guarantor of many financial and
economic transactions, the impact on the real wealth of the domestic population and on the
economy would be substantial. Third, if the government is still running a primary deficit, it will
not have the funds to pay for some of its key functions. Fourth, in the euro area the sovereign
does not have a domestic central bank that will finance its deficit. Fifth, after a
default/restructuring the banking system of the country would be unlikely to pass the stress
test and have sufficient adequate collateral to access the ECB's refinancing operations.
What are the implications of this analysis? Imposing haircuts on private investors can
seriously disrupt the financial and real economy of both the debtor and creditor countries. It
ultimately damages the taxpayers of both the creditor and debtor country. This is particularly
the case in a region like the euro area, consisting of advanced economies with highly
integrated financial markets - an integration we have encouraged for years. This is why such
restructuring should only be the last resort, i.e. when it is clear that the debtor country cannot
repay its debts.
Incidentally, this is the way the international community has functioned and cooperated since
the Bretton Woods agreement, which set up the IMF. Countries are never encouraged to
default or restructure their debts unless they are in a desperate situation and have no
alternative. This is why there have been relatively few cases of debt restructuring and
defaults, and they have affected poor and often undemocratic countries.
Where is the problem? The problem emerges when debt restructuring is carried out not as
the last resort but as a preventive tool, even becoming a precondition for receiving (or
providing) financial assistance, a point mentioned in some official circles since mid-October
2010. Debt restructuring would be a way to tackle not only dramatic cases of insolvency but
also any difficulties countries face in accessing the financial markets.
Why is it a problem?
First, as I already mentioned, it would not be a way to prevent taxpayers from suffering the
consequences of bad investment decisions. In our Monetary Union, given the integration of
financial markets and the single monetary policy, the taxpayers of the creditor countries
would suffer in any case. According to the Financial Times, for instance, a default on
Greece's debt would cost the German taxpayers alone "at least €40 billion".8
Second, this would be a way to punish patient investors, who are sticking to their investment
and have not sold their bonds yet, and are confident that with the adjustment programme the
country will get back on its feet. Restructuring would instead reward the investors who exited
the market earlier or short-sold the sovereign bond, speculating that they would gain out of a
restructuring.
Third, it would destabilise the euro area financial markets by creating incentives for
short-term speculative behaviour. Given that markets are forward-looking, they would try to
anticipate any difficulty faced by a sovereign by short-selling their positions, thus triggering
the crisis. This would discourage investment in the euro area because of its potential volatility
and perverse market dynamics.
Finally, such a measure would delay any return to the market by a sovereign, because no
market participant would be willing to start reinvesting in the country for a long period if they
know that this kind of investment might at some stage be penalised. This would thus
discourage private sector involvement and oblige the official sector to increase its financial
contribution.
A clear example is the fear that private sector involvement would be sought automatically
under the European Stability Mechanism. Faced with such circumstances, investors would
be sceptical about buying government bonds maturing after 2013. And the statement which
is often made in this country that "there will be no restructuring before 2013" does little to
reassure investors, as it implies that there might be one afterwards.
The proof of what I have just mentioned can be found in the data. Just looking at the yield
spreads between the government bonds of the three stressed countries and those of
Germany, it can be seen that they were gradually coming down last autumn until the day of
the Deauville agreement and then spiked up after the October European Council, in which it
was mentioned that preparatory work on the ESM would include "the role of the private
sector". Renewed public comments about a possible "soft restructuring" or "reprofiling" of the
Greek debt in April this year produced an immediate spike of the spreads on Greek bonds,
with strong contagion effects to other euro area countries (see Chart 1).
To sum up, private sector involvement, if pursued imprudently, i.e. automatically rather than
as the last resort:
 does not help save taxpayers' money; indeed, it may cost them more money;

favours short-term speculation over long-term investment, which is certainly
undesirable;

discourages and even delays any new investments in a country implementing an
adjustment programme.
Given that such a system - of preventive PSI - does not exist elsewhere in any other parts of
the world, the euro area would be seen by investors as handicapping itself and it would feel
the effects of discrimination. The euro area, in terms of both sovereign and private
investments, would become less attractive. The financial system in particular would be highly
exposed to sovereign restructuring.
It would also put the euro area at odds with the rest of the international community. Given the
damage that such a system would inflict on other investors and countries, the other
shareholders may be discouraged from supporting IMF programmes in the euro area.
This is how a good idea can turn into bad practice. Continuing to pursue it suggests strong
masochistic tendencies.
How should the problem be solved? How can we prevent taxpayers of the good performers
in the euro area from being asked to foot the bill for the excesses of the bad performers?
EMU is based on two pillars. The first is price stability, ensured by an independent central
bank. The second is sound public finances, promoted by the Stability and Growth Pact. This
second pillar has not worked properly and needs to be repaired.
Including some form of automatic private sector involvement does not repair the SGP. It
actually weakens it by delegating discipline to the financial markets, which we know are late
and pro-cyclical. It makes debt restructuring easier and thus discourages fiscal discipline.
The only way to protect taxpayers in "virtuous" countries is to avoid over-indebted countries
from easily getting away with not repaying their debts; the payment of debts should be
enforced, through sanctions if need be. When countries go off track they can receive
financial assistance only in exchange for strict adjustment programmes, including asset
sales, which allow these countries to remain solvent. Respect for contracts is the one of the
key principles underlying the market economy. It is also the basis of monetary union between
sovereign countries.