Financial Stability Paper No. 27
By Martin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor
In recent decades, the common perception had been that sovereign debt crises were unlikely to occur in advanced economies. Events in the euro area over the past few years, however, have undermined this view.
The sovereign debt restructuring in Greece and the events surrounding the IMF-EU support packages for Ireland, Portugal and Cyprus have exposed fault lines in the existing practices for sovereign debt crisis resolution — perhaps most importantly, an overreliance on official sector liquidity support. This paper argues that the current approach is suboptimal for five main reasons: (i) it increases the risk of moral hazard; (ii) it incentivises short-term lending, which can increase the risk of liquidity crises; (iii) it puts an inequitable amount of tax-payer resources at risk; (iv) substantial official sector holdings of an insolvent sovereign’s debt can complicate negotiated debt write-downs; and, (v) it can delay necessary reforms thereby requiring larger policy adjustments to be implemented when action is eventually taken.
Sovereign default and state-contingent debt