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By Jan Strupczewski
BRUSSELS — Reforms to European Union budget rules are being criticised for giving politicians too much leeway in enforcing the rules. But a German proposal means bond markets may ultimately become the main enforcer, imposing the toughest discipline that countries have seen so far.
Under draft reforms agreed by EU finance ministers last week, punitive sanctions on states that spent too freely would not be automatic; any decision by ministers to move forward with sanctions could be halted by a blocking minority.
Germany, which had been advocating near-automatic sanctions, yielded to French demands for more political discretion in the process. As a result, the reforms were roundly criticised by some northern European governments and by the European Central Bank for being too soft.
But in exchange for its concession, Germany secured the backing of France to change the European Union treaty, the 27-nation bloc's main law, to allow the creation of a permanent mechanism to resolve economic and debt crises.
Although this aspect was not publicly stressed by Berlin and Paris, such a mechanism would involve the possibility that a euro zone country would not pay back its creditors in full, sources among senior euro zone officials told Reuters.
Because of this possibility, investors would demand higher premiums to lend money to euro zone governments that appeared in danger of overspending.
That could create a strong incentive for governments to obey the EU's fiscal rules — a stronger incentive than they have faced under the current system, which does not spell out the possibility of a country partially defaulting on its debt.
"Instead of the politicians, it would be the markets punishing a country because they would know the euro zone would not necessarily come to its rescue," said Barbara Bottcher, head of European policy research at Deutsche Bank.
"This would be much more efficient than the political procedure."
FUTURE OF EURO ZONE
This year's debt crises suggest enforcement of the EU's budget rules, which say governments' budget deficits should not exceed 3% of gross domestic product while public debt must not stay above 60% of GDP, may be key to the long-term cohesion of the euro zone.
Under the draft reforms, new sanctions would be introduced for governments which did not try to bring their budgets close to balance or into surplus. Countries would be punished for tolerating, despite EU warnings, macroeconomic imbalances such as real estate bubbles or large current account imbalances.
EU leaders are expected to approve the draft changes at a summit late this week, after which governments will try to hammer out an agreement on numerical details such as the size of fines for rule-breakers and the speed at which countries will be required to adjust excessive deficits. The process is likely to take at least several months.
Some investors view Germany's climb-down on automatic sanctions last week as a potentially fatal flaw in the EU's reforms.
Enforcement of the rules "is a weakness, and as long as there is a weakness financial markets could focus on it and try to take advantage of it," said Nick Kounis, chief European economist at ABN Amro.
"The compromise means that politicians are in the end masters of their own fate; that was exactly the problem with the institutional framework before…
"Where we are now is not too far from where we were before. This new mechanism gives politicians a chance to interfere and get themselves off the hook — that is the risk."
MARKET DISCIPLINE
Others, however, think Germany's approach to the reforms will make life much harder for spendthrift governments.
In the decade after the launch of the euro in 1999, there was no provision for a country to default on its debt, so the markets assumed countries breaking the budget rules would eventually be bailed out if necessary by their richer peers.
This let profligate countries keep borrowing at ultra-low rates, giving them little incentive to tighten their belts. Fines threatened by the EU were never imposed, and in any case would likely have been too small to force compliance; larger fines would simply have worsened countries' financial plight.
To avoid a regional crisis, Germany was ultimately forced to take part in a 110 bln euro bailout of Greece and help establish a 750 bln euro temporary safety net for other indebted euro zone countries.
Now, by revising the EU treaty to create a permanent mechanism in which countries could undergo an "orderly insolvency", Germany would be ensuring that future crises might be handled without bailouts.
This prospect would keep bond spreads high for fiscally irresponsible governments, putting them under pressure to mend their ways. In effect, Germany would be bringing in the bond markets as the top enforcer of fiscal discipline.
"In the past ten years the market process for punishing government profligacy has not worked — the question is why?" said Elga Bartsch, European economist at Morgan Stanley.
"Is it because markets have always known that countries would be bailed out? If (a default mechanism) would give markets more ammunition to exercise their function, it might actually be a breakthrough."
German Finance Minister Wolfgang Schaeuble appeared to have exactly this logic in mind when he told the Bild am Sonntag newspaper at the weekend that holders of government bonds should "take on responsibility" during any future sovereign debt crisis in the euro zone.
TREATY
Germany's approach carries risks. Even a partial default by any country would risk destabilising the entire euro zone.
Also, any revisions to the EU treaty would need to be ratified by all the EU's 27 members — a very difficult, complex and time-consuming process that many euro zone policymakers believe could fail.
But Germany seems to be calculating that these risks are acceptable when set against the dangers of remaining on the hook for future bailouts.
And even if Germany fails to secure the treaty revision, it has succeeded in signalling that it will not necessarily stump up money for any future euro zone bailout. This in itself could keep bond spreads high, partly achieving the purpose of an orderly insolvency mechanism.
"It is a puzzle with different elements and even though each element might not be the optimal version, when they all come together, it is a major upgrade of the governance structure of the monetary union," said Deutsche Bank's Bottcher.
