Euro-zone Update (2): European Stability Mechanism and Collective Action Clauses

Bloomberg announces today that the EU has reached an agreement on that thorny issue. Here is the announcement by the Eco-Fin Council of the EU, corroborating that report.

The Economic and Financial affairs Council statement reads as such: “Rules will be adapted to provide for a case by case participation of private sector creditors, fully consistent with IMF policies. In all cases, in order to protect taxpayers’ money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan.” As Bloomberg puts it, “the proposal is designed to address “collective action clauses” for debt issued after temporary crisis facilities expire in 2013. Such clauses allow bondholders to change terms of their contracts. ”

This is a relevant development because as the Euro-zone mumbles and stumbles through its process of fiscal reform, it negotiates and renegotiates arrangements. One may be pleased or displeased with it but it’s the nature of the “business”. This discussion about the shape of the permanent version of the EFSF has been at the center of debates about the future of Euro-zone governance.

The main problem with the negotiations of this permanent mechanism, which is temporarily being called the European Stability Mechanism (ESM), is the lobbying that Germany has made for burden sharing by the private sector in case assistance is requested by a Euro-zone country. Parallel to this, Germany has voiced concerns about the dubious constitutionality of creating such a permanent mechanism under the present framework of the Lisbon treaty, as it is implemented in German Law. Germany matters because it will undoubtedly be the biggest contributor to the fund.
The German demands have gone through several versions. First, they wanted member states who violate the SGP to lose their council votes, similarly to what happens in case of human rights violations. This was allied with a demand for there to be an immediate haircut to the debt interest payments, so as to insure burden sharing by the private sector, and that SGP fines, under the preventive arm of the Excessive Deficit Procedure would be made automatic.
Then, in what became known as the Deauville Agreement, the French managed to get them to join them in supporting that only ex-post punishments would be automatic, so that any preventive action would have to be agreed by the Council. At that time I was outraged at the lack of coverage that was given to the fact that the French supported withdrawing voting rights from non-compliant countries.
Fortunately that last proposal was withdrawn in the October 29, 2010 Council Meeting. So the German position was cut to only demanding private sector burden sharing. So what happened last night was that Germany gave up yet another one of its demands.
So is this bad for Germany? Well no, not really. It’s probably best. The fact is that if the private sector has to share burden, the German banking sector will be one of the most burdened ones. So the German economy will probably be amongst the most benefited by the German government dropping this demand. Regarding the other demands that were dropped along the way, the council votes penalty was simply outrageous. Regarding the automaticity of preventive fines, the incentives were right, but to be honest a change of focus to the ESM would be a healthy change of pace.

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