ECB Opposition to Involuntary Private Sector Involvement (PSI) in Resolution of Private Debt Crisis

October 13, 2011

The ECB’s monthly publication seldom elicits market notice.  The main editorial every month rehashes very closely the content of the statement released immediately after the Governing Council meeting and therefore contains no fresh information.  The first main article in the latest issue, which presents a run-down of the regional economic situation, became news rather than a commentary on the news by warning that coerced participation of private holders of trouble European national bonds in the resolution of the region’s sovereign debt crisis could damage confidence in the euro in an enduring way

The paragraphs in question can be found within Box 5 on pages 45 and 46 of the October Bulletin.  Three reasons why monetary officials oppose private sector involvement are presented.  First, note is made that PSI could impair the whole regional banking sector, not just banks in the affected countries, and require “large-scare bank recapitalization.”  A second negative channel of influence involves the risks of contagion from one country, whose problem is addressed, to others.  These two thoughts had been expressed consistently and repeatedly in the past by Trichet and other ECB officials and would not have elicited a market reaction today if ECB officials had stopped there. 

A third factor, however, introduced the possibility of risk to the euro’s reputation.  Here is that language:

PSI could also damage the reputation of the single currency internationally, possibly adding to volatility in foreign exchange markets. In particular, public and private international investors may be cautious about investing large portions of their wealth in assets denominated in a currency of sovereigns that may not fully honor their obligations and may be willing ex ante to rely on PSI in some circumstances.

Furthermore, the longer-term implications of PSI, particularly for the prevention of sovereign crises inside a monetary union, are not clear-cut. On the one hand, PSI is meant to exert a beneficial long-run effect by strengthening market discipline.  Creditors will have an incentive to closely monitor the sustainability of a sovereign’s public finances and are likely to charge commensurate risk premia. This is an important mechanism through which to exert a disciplining effect on a sovereign. On the other hand, PSI may aggravate moral hazard with regard to the borrower. If a sovereign knows that it does not have to fully honour its contractual obligations and could instead restructure its debt, it may be tempted to accumulate excess levels of debt. Strengthened market discipline through higher risk premia is likely to be insufficient to counteract the sovereign’s weakened incentives.

Against this background, the ECB has strongly advised against all concepts that are not purely voluntary or that have elements of compulsion, and has called for the avoidance of any credit events and selective default or default.  All euro area governments need to demonstrate their inflexible determination to fully honor their own individual sovereign signature, which is a decisive element in ensuring financial stability in the euro area as a whole. The risks of PSI underline the importance of strong governance in a monetary union to ensure sound fiscal positions in all member countries at all times. They also emphasize the need to have an effective crisis resolution mechanism at the European level – the European Financial Stability Facility and, from mid-2013, the European Stability Mechanism – to ensure that financial assistance can be provided effectively and under strict conditionality should a euro area country experience problems in the future with obtaining refinancing in the markets.

The ECB was created in the image of the German Bundesbank, whose independent interest rate decisions prior to 1998 had determined the policies of many other European central banks as well.  The ECB’s opposition to so-called bond “haircuts” has pitted it against the German government.  To suggest that involuntary bond write-downs could endanger the euro and the ECB’s success in preserving its stability goes to the heart of why German voters reluctantly agreed to give up their beloved D-mark for the euro.  Before that happened, the German currency held the same sacred symbolic significance for Germans that people in the United States pace in the American flag.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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