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Soverign dept restructuring

According to the International Monetary Fund (IMF), past experiences demonstrate that ‘debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way’. To date, no EU-level legislation covers sovereign default or sovereign debt restructuring. Consequently, should any EU Member State face a problem with unstainable sovereign debt stock, each situation is solved on ad hoc basis. The lack of a transparent EU framework could entail additional costs

The 2008 financial and economic crises led to a substantial contraction of EU Gross Domestic Product (GDP); euro area GDP only returned to its pre-crisis level in 2016, representing billions of euros of lost wealth generation and accumulation. However the crisis is not yet over, in recent years, sovereign debt levels have increased significantly. Some countries have used budgetary resources to support a failing banking sector and increased budgetary spending on infrastructure projects, whilst facing a decrease in tax income as well as an increase in statutory and non-statutory social expenditure (automatic stabilisers). Five out of 19 euro area countries have a debt-to-GDP ratio exceeding 100 %, and only five are below 60 % (stability and growth pact criteria). In contrast, in 1995 only two countries exceeded the 100 % threshold, with 12 countries below 60 %.

Several fiscal consolidation measures were implemented to restore these countries’ public finances: taxes were increased and public expenditure cut. All these measures should, according to the economic literature, result in depressed domestic demand; which is indeed the case in many European countries. While the effects of structural and fiscal consolidation measures generate benefits after a certain time lag, from a short term perspective, consolidation could amplify the negative cycle. Fiscal consolidation could also lead to increased short term political risk.

The absolute or relative level of debt is not, as such, a direct source of concern; what matters more is the speed at which the debt increases. Increased levels of public debt create fears of debt sustainability problems in some countries – a situation generally defined as where a country’s growth rate is lower than its real interest rate, and which might ultimately lead to payment default. In such a situation, the sovereign debt is perceived as riskier, implying an increase in the interest rate the country pays to finance itself. In turn, higher interest rates produce higher debt servicing costs, resulting in a negative spiral.

The EU has put in place new tools to better manage financial and economic stress and to avoid situations in which a local problem becomes systemic, putting the proper functioning of the economic and monetary union at risk (e.g. European Stability Mechanism, Single Supervisory Mechanism, economic governance – six pack, two pack, European semester, Banking Union). As the structure is not yet complete, it is not at an optimum level to tackle and reduce risks (see Testing the resilience of Banking Union: Cost of Non-Europe Report). Some elements are missing, e.g. a European deposit insurance scheme and a mechanism to restructure sovereign debt within the euro area. Completing the EU’s toolbox would have a significant potential added value in case of renewed stress or shocks.

Reference: Briefing European Parliamentary Research Service