State contingent debt as insurance for euro-area sovereigns

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State contingent debt as insurance for euro-area sovereigns

Since the financial crisis, EU countries' economies have recovered to the point that they are exiting their adjustment programmes. Institutional stabi

Publishing date: 26 April 2018
Authors: Maria Demertzis Stavros Zenios

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The euro-area sovereign debt crisis is receding. Europe is on a recovery path, growth is broad-based and unemployment is falling. One after the other, countries hit hardest by the crisis are exiting their adjustment programmes. However, debt remains high in most countries and future debt crises should not be ruled out. While the memories are fresh, it is a good time to think about insurance against future shocks. Such insurance schemes must involve risk sharing with the markets. They weaken the bank-sovereign doom loop from the sovereigns’ side, and not just from the banks’ side as pursued by the banking union, and make for a more resilient euro area.

The promotion of the banking union and the establishment of a European Monetary Fund are institution-based solutions to crises. Banking union provides the safety regulations that will make banking institutions more resilient, while the EMF is a ‘fire brigade’ to be called on in emergencies. What has not been tapped are the markets, whose tolerant behaviour to sovereign demands encouraged the built up of debt, while their finicky response exacerbated the crisis.

Taking ongoing G20 discussions on sovereign contingent debt as the point of departure, the authors argue that these instruments could provide market-based insurance to protect the euro area from future debt crises. Risk-sharing with the markets is a constructive way forward in the context of the Franco-German debate on risk-sharing among states versus system-wide risk reduction. The financial innovation of contingent debt is a practical euro-area reform that would not introduce risk-sharing between states or require institutional reforms or Treaty changes. However, coordination would be needed.

About the authors

Maria Demertzis

Maria Demertzis is a Leader at ESF, The Conference Board Europe, former Senior fellow at Bruegel and part-time Professor of Economic Policy at the Florence School of Transnational Governance at the European University Institute. She was Bruegel’s Deputy Director until December 2022. She has previously worked at the European Commission and the research department of the Dutch Central Bank. She has also held academic positions at the Harvard Kennedy School of Government in the USA and the University of Strathclyde in the UK, from where she holds a PhD in economics. She has published extensively in international academic journals and contributed regular policy inputs to both the European Commission's and the Dutch Central Bank's policy outlets. She contributes regularly to national and international press and has regular column that appears twice a month in various EU newspapers and on Bruegel’s opinion page.
Stavros Zenios

Stavros Zenios is a Cypriot citizen with a long career in the USA. His current research focuses on sovereign debt issues, especially in relation to the challenges posed by climate change and political risks. He is working on the development of stochastic dynamic models for debt sustainability analysis and risk management for sovereigns, on sovereign contingent debt, and on the asset pricing effects of political risks. He has published more than 150 articles in leading academic journals, encyclopedias, and handbooks, and edited numerous collected works. He regularly appears on national media discussing issues relating to the economy, transparency and corruption and is consulted by the international press on Eurozone crisis issues. He was Vice chairman of the Cyprus Council of Economic Advisors and served on the Board of the Central Bank of Cyprus. He served two terms as President of UNICA-Universities of European Capitals and two terms as Rector of the University of Cyprus.

He is a Professor of Operations Management and Finance at Durham University (UK), on sabbatical leave from the University of Cyprus, where he has been a Professor of Finance and Management Science since 1991. Prior to that, he was a tenured faculty member at the Wharton School, USA, where he remains a Senior fellow of the Financial Institutions Center.