October 25, 2010 7:32 pm

Paris and Berlin at odds over default system

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France and Germany put on a show of unity last week when they agreed to water down new budget rules for EU members, but their differences over how to deal with future Greek-style debt crises threaten to place a fresh strain on the relationship.

Under the compromise struck in Deauville, Angela Merkel, Germany’s chancellor, accepted sanctions that must be approved by finance ministers, rather than be imposed automatically, to ensure budgetary discipline among members of the common currency.

In exchange, Nicolas Sarkozy, French president, agreed to negotiate changes in the European Union’s Lisbon treaty, to provide a permanent “crisis resolution mechanism” to cope with the threatened default of any member state in the future.

However, Paris and Berlin are at odds as to what this mechanism should cover.

There is also no certainty that all 27 EU members will agree to negotiate treaty changes after the tortuous process of agreeing the Lisbon treaty.

Several member-states expressed their objections to re-opening the treaties at a meeting of EU foreign ministers on Monday.

“After 10 tortuous years we managed to chain the fierce beast and lock it in a chest for at least another decade,” said one official from a smaller member state. “Who guarantees us that the wretched animal will not leap out and devour us all?”

As for the content of the mechanism, Germany wants to install a procedure for orderly debt default. It believes the possibility of sovereign default will force the markets to discipline profligate governments by making them pay higher borrowing costs.

One idea being canvassed is to form a “Berlin club” of creditors, along the lines of the Paris and London clubs, to ensure orderly rescheduling of sovereign debt.

France accepts the private sector should be involved, but it advocates doing so in a co-operative way through roll-overs.

“There are ways of getting the private sector involved that could have a lower cost,” said a French official. “Automatic debt restructuring could be more damaging than the illness it is trying to remedy.”

The French worry about the stigma attached to countries that default, which could lock them out of financial markets for years.

They also worry about aggravating financial market instability and speculation against weaker eurozone economies.

One senior Elysée figure described the orderly default idea earlier this year as “totally stupid”, pointing out that France had not defaulted since Napoleon.

“For the French, sovereignty is absolute, so a state cannot go bankrupt,” said Katinka Barysch, deputy director of the Centre for European Reform, a think- tank. “They do, of course. There are plenty of history precedents. But to plan for it may seem harder for the French than for Germany’s legalistic minds.”

Meanwhile, Paris frets that Germany will not extend the three-year life of the €440bn ($614bn) eurozone rescue package that Mr Sarkozy regards as an important breakthrough in co-ordination and solidarity between member states.

Ms Merkel has said she will not extend the €440bn fund in its current form.

The future crisis resolution mechanism would replace the European Financial Stability Facility, combining both a financing arm and a restructuring mechanism, say Berlin officials.

“It comes very close to an insolvency mechanism, but those words have negative connotations.” It would only affect new borrowing after the treaty changes had come into effect.

“It does not have to be a pot of money,” said one official. “It could be something like Brady bonds.” These were issued by Latin American countries after their defaults in the 1980s.

Additional reporting by Peter Spiegel in Brussels

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