Euro zone leaders think they have found a bone to throw at markets at this week’s summit. They’re considering reviewing the senior ranking of the Euro zone bailout fund’s loans, in the hope this will address the concerns of private creditors. Investors should be wary.
Sovereign debt investors have been gripped with a seniority complex ever since Spain’s euro 100-billion bailout was announced this month. They fear that private creditors would take all the pain if Spain were ever to restructure its debt. The unintended consequence would be that Madrid would find it even harder to fund itself, and be forced into a full bailout.
The debate hinges on whether the Spanish banks’ bailout loan will be provided by the European Financial Stability Facility (EFSF), which has a pari-passu ranking, or the future European Stabilisation Mechanism (ESM), which benefits from a “preferred creditor” status, junior only to the International Monetary Fund. The solution could be to waive the ESM’s seniority on a case-by-case basis.
However, that will not ensure that creditors get a fair deal in a restructuring. The Euro zone’s loans to Greece did not have preferred creditor status, and yet they avoided a haircut in the country’s debt swap earlier this year. And the European Central Bank got away scot free after a sleight of hand excluded its bonds from the debt swap.
Removing the preferred creditor status wouldn’t necessarily be a clever move. By itself it wouldn’t calm markets, or bring down Spain’s funding costs. And it may stir anti-euro sentiment in the core, leading taxpayers to believe they made yet another concession to lazy southern Europeans.
Euro zone leaders could find other ways of addressing the seniority complex, if they really want to. They could subordinate themselves to private creditors. The EFSF can legally underwrite first loss risk, and it can invest in junior tranches of co-investment funds. Both mechanisms are untested so far, and it would mean that governments accept losses ahead of private creditors, something that may not be politically acceptable. But what’s certain is that EU leaders have to come up with more than a seniority fiddle to avoid a post-summit market backlash.
