July 25, 2012
The debt redemption fund, as proposed by Germany’s Council of Economic Experts, has recently been the subject of controversial public discussion. It aims to use national gold and FX reserves to collateralise debt redemption payments. Do euro countries have sufficient reserves to qualify for the scheme?
The concept by the Council of Economic Experts aims to pool the share of public debt of euro area countries that exceeds the Maastricht threshold of 60% of GDP in a debt redemption fund. Each country’s share of the excessive debt would be reduced by tax revenues earmarked for this purpose over a period of up to 25 years. Structural reforms and a debt brake in national constitutions would ensure fiscal sustainability in participating countries. However, a risk remains: Countries could stop their redemption payments to the fund once their share of excessive debt has been transferred to the fund. As a remedy, the Council of Economic Experts proposes to collateralise the outstanding redemption payments with gold and FX reserves at a ratio of 20% of the excessive debt. Are the current gold and FX reserves in Euro area countries sufficient?
The table shows that Germany, France, the Netherlands and Austria would be able to fully collateralise their excessive debt using their gold and FX reserves, as would Cyprus and Malta. However, this does not apply to Greece, Ireland, Spain, Italy and Belgium. These countries only have a limited overall volume of gold and FX reserves. Portugal would manage only just in 2012 to collateralise its excessive debt. According to the proposal, countries under an EFSF programme would not become part of the debt redemption pact. But even if these countries joined with an unchanged level of public debt after their programme expired, their gold and FX reserves would not be sufficient.
As regards logistics, the proposal by the Council of Economic Experts provides for a roll-in phase: The debt overhang would not be paid-in at once but in the course of refinancing rollovers within a five-year period. The collateral, however, would be deposited already at the very beginning of the phase: Under these circumstances, some countries would not be able to complete the roll-in-phase. Ireland would have to end its participation after two years, and Greece after three years – provided that politicians resisted the tempation of accepting a lower collateral ratio.
In Europe, the idea of the debt redemption pact has many advocates. It cannot be excluded that the advocates would aim for a lower collateralization rate or extend the range of the eligible collateral towards less liquid assets. Even the Council of Economic Experts has meanwhile changed its opinion and in recent statements referred only to a collateralisation of “assets up to 20%” of the debt overhang. The term assets is a broader term than gold and FX reserves and could also include state-owned enterprises. Using those as collateral could be counterproductive as regards future privatisation efforts.
Irrespective of that, the debate on the redemption fund could be inspired by the cash reserve of the ESM and claim the mutualization of the redemption fund’s gold and FX reserves. The table shows that the total debt overhang of EUR 3.1tr would be covered by a pooled collateralization power of 3.2tr. From a legal point of view, that procedure would be problematic (no-bailout clause). And: The risk of moral hazard that could arise from further mutualisation of liabilities would make it more than doubtful whether the current equilibrium would be a permanent one. If the countries that failed to adhere to fiscal discipline in the past were covered by the huge share of the collateral provided by stronger countries, their debt overhang could increase again.
What could be the alternative? Could the recent gold price rally make a revaluation of the valuation reserves a valuable option? That would be a good task for the countries of the periphery, as gold reserves are making up a larger share of their portfolios than FX reserves. However, the gold price has always been subject to huge volatility. Moreover, investors could see the activation of valuation reserves as an indication that the national central banks would regard the purchasing power of their currency as diminishing.
If the proposal by the Council of Economic Experts were fully implemented, a further extension of gold and FX reserves would be inevitable. If that extension were financed by fresh ECB money, it would lead to a balance sheet extension. While the asset side of the balance sheet would increase due to the purchased stock of gold, the liabilities side would increase by the creation of central bank money. In case of future increases in the gold price, again, valuation reserves would have to be increased.
The fact that using gold reserves as collateral for the debt redemption fund would be tantamount to a clear political order to the central banks remains problematic legally. Despite the pragmatism seen in European monetary policy during the past two years, this is still prohibited by the European treaties.
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