How to ease the eurozone’s solvency crisis

by Paul Achleitner

Financial Times
May 16, 2011

There was a world before the crisis and there will be a world after deleveraging, but right now we are in limbo. The liquidity crisis triggered by Lehman’s collapse has been overcome, but the cause of the crisis – excessive leverage – still has to be addressed. Until now we have simply shifted debt from consumers to banks; and from banks to central banks and governments. Now there is no one left to pass it on to and the crisis is showing its real face: solvency problems.

This week’s fraught talks over the terms of Greece’s bail-out illustrate that solvency and liquidity issues are now interwoven. It is clear that private capital is not willing to fund some sovereign issuers on acceptable and sustainable terms. The uncertainty about a potential default is simply too high. To defuse the sovereign debt crisis, eurozone governments have set up joint funding mechanisms – the European financial stability facility and European stability mechanism – that act as surrogate capital pools. That was crucial to stabilise the situation. But these are emergency safety nets meant to address liquidity problems, not fundamental solvency issues.

In principle there are two ways to deal with solvency issues. In a US-style approach, all creditors bear some loss and the debtor starts anew with a relatively clean balance sheet. By contrast, in a traditional continental European approach to restructuring, creditors continue to fund the debtor to allow for a gradual adjustment over a longer period. In return the debtor must constantly demonstrate progress in fixing the underlying business and solvency problems.

The creditors of peripheral eurozone countries such as Greece prefer a “work-out” over time to the US-style haircut that the financial markets increasingly demand. The reasons are clear. These states’ biggest creditor is the European banking system, including private institutions already struggling to meet increasing regulatory capital requirements and central banks, especially in the countries most affected. A stiff haircut – it would need to be about 50 to 60 per cent to be effective – would require governments to recapitalise part of the banking system, again increasing the sovereign debt burden. Add market speculation on who might be next and the temptation for other debtors to soften the blow by opting to “burn the bondholders”, and it is clear why so much emphasis must be put on a work-out solution.

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