Careless talk

EU debt: Europe’s promises won’t make peripheral debt safer. EU leaders last week tried to calm market nerves by stating that a new default mechanism for sovereign debt won’t affect existing investors. The statement eased some of the jitters. But it won’t make it any easier for peripheral countries to reduce their debt. And the new bailout regime could make life harder by raising the cost of future borrowing.

It’s no wonder euro zone bond investors panicked when politicians began to speak openly of a sovereign default mechanism. The statement on November 12 by Germany, France, the United Kingdom, Spain and Italy made it clear that the new regime will only apply to debt issued after the framework comes into force, probably in 2013. It also avoided any mention of debt haircuts.

This has calmed markets a bit. However, the statement doesn’t make it any more likely that peripheral countries will be able to bring down their debt. Take Greece. By the end of 2014, after the current bailout package from the EU and International Monetary Fund has expired, it will still have debt of around 140 percent of GDP, according to the IMF’s most recent forecast. Many investors believe that the existing debt will still have to be restructured.

Moreover, even though it will not apply to bonds issued before 2013, the new bailout regime could still make things harder for any country with weak finances. The introduction of a less creditor-friendly regime could raise borrowing costs, increasing the probability of a default.

It’s still not clear how the new mechanism will work. However, several ideas are emerging. One concept is to insert “collective action” clauses into future debt to force creditors to accept restructurings that have been approved by the majority. The regime could also make explicit that any new bailout funds rank senior to existing debt. This would create a two-tier sovereign debt market, and could make new bonds more expensive to issue.

EU leaders may have belatedly realised that their mission to curb moral hazard could backfire. But while their reassurances have eased fears of an immediate crisis, they may have simply postponed the fallout.