As of this writing in December 2019, a remarkable debate over sovereign debt contract clauses is going on in Rome, in the Italian parliament (see here and here).  Indeed, the debate has become so heated that there is a risk that the government will fall.  Basically, the main opposition party (the League) is accusing the government, and especially the prime minister, of having betrayed the country by agreeing to a future set of reforms to the European Stabilization Mechanism (ESM) treaty (here).  But it’s not just the opposition that is against ESM reform. Luigi Di Maio, the leader of the 5 Stars Movement and Italy’s Foreign Affairs Minister, has jumped on the League bandwagon and stated that the government should not sign off on the ESM reform (here). Hence, the political crisis (here).

There are many puzzling elements related to this crisis, including that it partly focuses on a subject—Collective Action contract clauses (CACs) in sovereign bonds—about which we suspect that some of the main objectors are clueless.  For instance, when asked what these scary horrible CACs were, the leader of the League did not seem to know. Yet, they are part of the supposed ‘betrayal’.  Plus, these reforms to the ESM being objected to now were ones that the League and the 5 Star Movement agreed to when they were in government together first in November and December 2018 (here) and then again in June 2019 (here).

The CAC reforms agreed to in November 2018 were for Euro area countries to move on from the basic CACs that had been introduced in 2013 after the sovereign debt crisis of 2011-12.  Time and experience had demonstrated that these first generation CACs had flaws (here). So, in November 2018, Euro area policy makers agreed to try and move to new and better CACs of the form being already widely used in the international markets, starting in 2022.

The basic argument of some opponents of the ESM reform is that these enhanced CACs, by making it easier for the sovereign to conduct a debt restructuring, will send a signal to the market that the sovereign is more likely to restructure. That in turn will cause yields to rise and end up causing the very crisis that the clauses are intended to protect against. (As an aside, at least one member of the League also opposes enhanced CACs on the grounds that these clauses will make it too difficult to redenominate Italian bonds into lira if Italy abandons the euro (here).)

There is a simple reason why this concern is baseless.  It has to do with the ‘local law advantage’ that most Euro area countries, and especially Italy, currently possess (for discussions, see here and here).  This is the fact that over 99% of Italy’s sovereign debt is governed by local Italian law.  That means that any Italian government that wishes to restructure its debt has a wide variety of options it can turn to (we describe these options in detail in our recent article here; see also Weidemaier, 2019, here).  And most, if not all, of these options are a lot easier to implement for a government that affirmatively wishes to force a restructuring on its creditors than CACs (enhanced or not).

To illustrate this point, we take the simplest of scenarios.  Assume that the Italian government tells its creditors that it is in trouble and needs to reduce its debt.  It tells the creditors that it will give them a ‘take it or leave it’ offer of 60 cents on the euro.  It also explains that those creditors who do not take the offer will be consigned to the outer darkness of Hades (ie, they simply won’t get paid, ever).  What do you think the holders of local law governed Italian bonds will do?  The prospect of suing the Italian government, in Italian courts, under contracts that do not contain waivers of sovereign immunity from suit or execution, is not going to be attractive to any creditor.  In other words, game, set and match to the Italian government that wishes to opportunistically restructure. It doesn’t need CACs to do this.

Or one could get fancier. If the government does not like the prospect of unpaid creditors running around complaining to the rating agencies and press and so on, the government could tell the creditors that those who refuse the restructuring offer will have a withholding tax imposed on them.  Ordinarily, in internationally issued sovereign bonds, there will be contract provisions constraining the sovereign from imposing such taxes on bondholders.  And a small segment of Italian debt does contain such constraints.  But that is only about 1% of Italian sovereign debt stock.  For the other 99% of the debt, the sovereign can threaten such a tax on those who refuse its offer.  And it is unlikely that many will hold out from such an offer, since the alternative is litigation over the legality of such an act in local Italian courts that will likely end in an expensive loss for the creditors.  Again, the point is that CACs, enhanced or not, do not give a government that has 99% of its debt under local law any advantage in terms of being able to restructure its debt.

We could go on.  There are other powerful options that the Italian government possesses as well, such as that under Article 3 of the Public Debt Act of 2003 that arguably allows Italy to conduct a unilateral extension of maturities (for discussions, see here (Edelen et al 2013) and here (Cervantes et al 2019)).

So, are investors concerned about this immense restructuring power that the Italian sovereign possesses?  As of today, they are not.  If they were, they would stop lending quite so much to Italy under local law and Italy would instead be forced to issue under foreign laws (as has been the case of Greece, since 2012).

A vivid illustration of the foregoing point is contained in the yields that Italy received in its October 2019 issuance of about $7 billion in debt in New York, under New York law.  These New York bonds have strong creditor protections (eg, they contain waivers of immunities, are not vulnerable to withholding taxes or Article 3 powers).  So, if investors were worried about Italy engaging in an opportunistic restructuring, we should observe a special premium for these bonds.  Guess what the premium was that investors were willing to pay to be protected against the various restructuring techniques that the Italian government might be able to use for its local law bonds (that is, the price premium on the New York bonds)?  According to the Director General of the Italian Treasury himself, somewhere between negligible and zero (here).

To reiterate, for a sovereign seeking to opportunistically restructure its debt, utilizing CACs (enhanced or not) will be the last option because doing so requires obtaining the approval of a super majority of the creditors.  And if creditors perceive misbehavior on the part of the sovereign, they will deny that approval.  Assuming we have a sovereign holding a local law advantage of the type that Italy possesses, CACs will be utilized only if the sovereign wants to do a market-friendly restructuring.  If anything, investors should be happy that the European authorities are pushing individual sovereigns towards taking the option of using CACs—an option that is much more market-friendly than the other restructuring options that countries such as Italy possess.

For doubters, the foregoing is empirically verifiable.  First-generation CACs were introduced in European sovereign bonds in January 2013.  And, just as we are seeing in the Italian parliament today, there were some then who worried that the markets would perceive their introduction as a sign that restructurings would be more likely and that, as a consequence, borrowing costs would rise.  Did they?  And, to put the question in the fashion that should be most relevant to the Italian parliamentarians: did the introduction of these 2013 Euro CACs increase the yields on local law bonds?

Multiple studies show that the foregoing concern did not materialize.  If anything, the markets appear to have reacted positively to the introduction of these CACs in local law European sovereign debt  (see articles by Carletti et al 2019, here, by Picarelli et al 2019, here, and Schumacher et al 2019, here).  And, if one examines the Italian results described by the abovementioned studies specifically, one sees that it is not an outlier suffering especially high costs, while the others obtain benefits.  Why?  Maybe because the fact that the sovereign is more likely to use a CAC that requires super majority creditor approval, rather than some much more brutal and unilateral method such as the imposition of a withholding tax, is something that creditors see as a positive.

So, why all the drama in Italian politics then?  Are those who oppose ESM reform really scared by something they don’t understand, or are they just pretending not to understand so as to mobilize their voters against the government?  As they say in Naples: ci sono o ci fanno.

Theresa Arnold is an Associate at the Raleigh (NC) office of McGuire Woods.

Ugo Panizza is Professor of International Economics at the Graduate Institute Geneva and Director of the International Centre for Monetary and Banking Studies.

Mitu Gulati is a Professor of Law at Duke University.


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