Michael Waibel is a British Academy Postdoctoral Fellow at the University of Cambridge.
After losing a disastrous war to the Ottoman Empire in 1898, Greece was unable to service its existing debt or to pay an indemnity. The major European powers, alongside private bondholders pushed for the establishment of an international commission of financial control. Greece reluctantly agreed. The commission, consisting of representatives appointed by Austria-Hungary, Italy, Germany, France, Russia, and Britain asserted direct control over the main sources of Greek public revenue to ensure their debt was serviced. They also imposed other limits on Greek fiscal autonomy such as control over public borrowing and the money supply.
Fast-forward 113 years. Greece is at the epicentre of yet another sovereign debt crisis. On May 2010, Eurozone governments and the International Monetary Fund, in Act I of the newest Greek debt crisis, devised a 110 billion € ad hoc assistance package to prevent a possible default by Greece, but it failed convince financial markets. By covering the Greek wound with one insufficient plaster after another for the past 18 months, the Eurozone doctors have allowed the contagion to spread to major Eurozone economies, such as Spain and Italy. Policymakers have been fighting a rearguard action to get ahead of an increasingly systemic debt crisis that threatens Europe’s decade-old single currency itself.
On 21 July 2011, in Act II of the Greek Debt crisis, the European Council proposed emergency measures to shore up financial stability in the Euro area. These measures include additional financing of more than 100 billion € for Greece, lengthening of maturities and reduction in interest rates to about 3.5 percent on existing programmes for Greece, Ireland and Portugal, plus technical assistance on measures to increase competitiveness and structural reforms designed to boost economic growth.
Eurozone leaders also called upon the private sector to contribute, on a voluntary and exceptional basis, to restoring Greek debt sustainability by swapping Greek bonds maturing between 2012 and 2020. Given the implicit threat of a Greek default, it is doubtful whether the exchange is free from elements of coercion – an important factor for the rating agencies assessing the country’s creditworthiness and for whether credit default swaps, essentially insurance against sovereign defaults, will be triggered. If they are, large payment obligations by banks, insurance companies and others could be an additional channel for contagion.
In the proposed restructuring, existing holders of Greek debt will be able to choose among four options, two par bonds and two discounted bonds. Holders who accept will give up one fifth of their claims, in net present value terms. This so-called haircut is substantially lower than the secondary market prices of Greek sovereign debt, a common indicator of the market’s estimated recovery on Greek sovereign debt, prior to the announcement of the second package. As a security for principal repayment, Greece will purchase AAA rated bonds using loaned funds. These credit enhancements are expensive, but likely represent a quid pro quo that the ECB and private creditors demanded in return for their blessing of the deal.
The envisaged debt relief to Greece may be insufficient to seriously dent Greek’s debt dynamics. Many analysts argue that a haircut in the neighbourhood of 40-50 percent would be needed to put Greek debt sustainability beyond doubt. Many details of how to share the burden of re-establishing Greek debt sustainability remain yet to be worked out. It is unclear, for example, whether the new debt will include collective action clauses (CACs) that could facilitate a future restructuring. Heated discussions will follow in national parliaments in the weeks ahead on the second rescue package for Greece, and the broader European policy response.
The Eurozone is also upgrading its broader policy arsenal and attempting to improve economic governance. The European Financial Stability Facility (EFSF), the Eurozone’s rescue vehicle incorporated in Luxembourg, will be given expanded powers. Once ratified by national parliaments (scheduled for the end of September), the EFSF will also be able to also lend before a crisis becomes acute, grant loans to governments to recapitalise financial institution that may find themselves in difficulty and, most controversially, buy government debt in the secondary market in exceptional circumstances by common agreement of Eurozone governments and on the basis of an ECB analysis recognising the existence of exceptional financial market circumstances and risks to financial stability.
The downgrade by Standard & Poor’s of the United States of America from AAA to AA+, with a negative outlook, on August 5, 2011 was an important factor behind the latest tremors in the Eurozone. In response, yields on Italian and Spanish debt spiked. The ECB Governing Council reactivated its Securities Purchase Programme which has been dormant since the ECB purchased large quantities of Greek debt in 2010 that led to a temporary tightening in Greek yields. Italian and Spanish tumbled following the ECB’s secondary market purchases from August 7 onwards. The deployment of one of the ECB’s most potent weapons is likely to provide only temporary relief to beleaguered sovereign borrowers. The ECB seemed to throw down the gauntlet to governments.
Over the medium-term, the Eurozone also agreed on setting up a treaty-based, intergovernmental financial institution, the European Stability Mechanism (ESM) to succeed the EFSF from 2013 onwards “to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality.” The ESM will have €80 billion in paid-in capital, and €620 billion in callable capital. Its effective lending capacity is expected to be €700 billion. Additionally, collective action clauses will become a standard feature of all Eurozone government bonds.
Disputes concerning sovereign defaults, a subject that I explored in my book Sovereign Defaults before International Courts and Tribunals, will be increasingly common. With perfect timing, an ICSID tribunal in Abaclat and others v. Argentina (formerly known as Beccara and others) rendered a decision on August 4, upholding its jurisdiction over Argentina sovereign bonds by a 2:1 majority. This development has important implications for treaty-based arbitration in relation to a wide range of financial instruments and could add an additional layer of complexity for governments that have negotiated bilateral investment treaties and need a sovereign debt restructuring.
Consider another example of a long-running dispute from Greece’s default in the interwar period. In Société Commerciale de Belgique, the Permanent Court declared two arbitral awards requiring payment of principal and interest on Greek external bonds enforceable. In 1925, Socobelge had concluded a contract with the Greek government for the construction of certain railway lines. Disputes arising under this contract were to be settled by a Mixed Commission. The contract included a loan to finance this construction, and Greece paid for this railway construction with external bonds.
In its 1932 financial crisis, Greece defaulted on these bonds. Socobelge resorted to arbitration under the contract. The 1936 Arbitral Commission gave two awards, entitling Socobelge to $6.7 million (about €400 million today) in compensation. Subsequently, Greece defaulted on these awards. In the negotiations followed, it promised only gradual repayment, in lockstep with its other external debt. Belgium exercised diplomatic protection and brought the case to the PCIJ.
After World War II, both Belgium and Greece received Marshall Aid from the United States. Some of the funds allocated to Greek reconstruction were deposited with Belgian banks and manufacturing companies. In December 1950, Socobelge managed to attach these funds while in transit through the Belgian payment system. Relying on sovereign immunity from enforcement, Greece maintained that Socobelge lacked legal title to these monies. The Belgian court held that neither sovereign equality nor international comity required immunity from enforcement and refused to vacate the attachment. But the Belgian government came under intense pressure from the US government to release the reconstruction funds for Greece. The parties reached an undisclosed settlement.
Two aspects of the European crisis resolution response thus far stand out. The first is the purely intergovernmental nature of the response, rather than being embedded in the EU’s treaty framework. This choice is driven in part by the need for speed, but also by the desire for flexibility and for ensuring a high degree of influence for the creditor countries. The second is that the United Kingdom is a curious bystander so far, apart from a bilateral loan to Ireland.
Any serious financial crisis in the United States could not be resolved without closely involving New York City. Likewise, the European Union will not be able to exit from its current turmoil without a constructive role played by its financial centre – London. Should the crisis deepen further, the City of London and the British government will face a choice: either they decide to meaningfully contribute to crisis resolution or London will risk losing the status as Europe’s financial centre over the medium term.
The growing core-periphery division in the European Union is cause for alarm. The club of countries with high creditworthiness is shrinking. It took far too long for all Eurozone governments to be in acute crisis resolution mode. Until Italy and Spain came under threat, Germany, France and others treated the crisis as one far from home. Austerity alone, so much is sure, will fail to return some governments to sound finances. Further deleveraging, and perhaps debt relief lies ahead. Some sovereign restructurings or measures of financial repression, such as exchange controls, will be hard to avoid. In retrospect, the collapse of Iceland’s banking system in October 2008 may seem like a storm in a teacup.