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Sovereign borrowing: Europe discovers law of unintended consequences

Collective action clauses introduced; Markets fail to take any comfort

On November 28, eurozone finance ministers released details of the so-called European Stability Mechanism (ESM), aimed at curbing the market volatility that was driving peripheral sovereign bond yields higher. Giving some comfort to bondholders is the plan to introduce collective action clauses on all debt issued after 2013, rather than automatic burden sharing, the German Chancellor Angela Merkel had pressed for when she launched the idea the previous month. CACs would enable creditors to pass, by a qualified majority, legally binding decisions to change the terms of payment, which might include a payment stand-still, maturity extensions, interest rate cuts and haircuts.

European sovereign bond markets spent much of November in turmoil after Merkel said she had the support of fellow European leaders for a permanent replacement for the €440 billion European Financial Stability Facility, which will mature in 2013. At the time she had made no reference to collective action clauses, which suggested that the new mechanism could be modelled on the concept of a sovereign debt restructuring mechanism. This was first conceived by the IMF a decade ago to facilitate an orderly restructuring of Latin American sovereign debt, though it was never implemented. Such a mechanism would allow for involuntary haircuts to sovereign debt.

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