Bloc’s default mechanism worries investors

Last month, European leaders backed the creation of a mechanism to allow governments to default when their debts become too big to pay. They are now realizing that private creditors are unlikely to accept losses on their loans without a fight. All last week, investors dumped Irish and Portuguese bonds, heightening speculation that the countries might soon have to follow Greece in seeking a European Union bailout. Sharp increases in the interest rates demanded for lending money to the two nations only abated after EU finance ministers reassured creditors that any forced «haircuts» – that is, a reduction in the total amount they are owed – from any restructuring or default would not apply to existing loans. The sell-off puts added pressure on EU finance ministers, who are debating what to do about Ireland’s woes and looking at how to create a permanent forum for sorting out debt trouble without market panics like last week’s – one that protects taxpayers from having to fund such expensive bailouts in the future. But asking for sacrifices from private investors after 2013 – when the current eurozone rescue fund expires – might be harder than it looked at first. The threat of not getting their money back in full would simply stop investors from lending to a state that is living beyond its means. And governments with shaky finances would face higher borrowing costs due to the possibility of default, giving them an incentive to put their houses in order. Taxpayers, especially in Germany, had balked at having to backstop the finances of highly indebted countries on Europe’s periphery after eurozone governments and the International Monetary Fund set up at 750-billion-euro emergency rescue fund this spring. So when Chancellor Angela Merkel convinced other EU governments last month that the bailout fund would not be extended beyond 2013 unless it also included private creditors, it was hailed as a victory in Germany. But by putting a time limit on financial help, the eurozone might have painted itself into a corner. Governments often repay existing loans by taking out new ones. It was the threat of such a loan deadline at a time that it had essentially been locked out of the sovereign debt market that forced Greece to seek a 110-billion-euro bailout in the spring. To avoid a similar panic from spreading to other countries with high debts – such as Spain, Ireland, Portugal or Italy – the huge eurozone backstop was set up. Its mere existence, governments hoped, would reassure investors enough to keep lending. But over recent weeks, concerns that the painful austerity measures implemented over recent months would kill off economic growth – or that governments might lose the political will to push through even more cuts – have grown. If the risk premium for Irish and other government bonds remains high, the countries might have to ask for help soon – a move that would allow them to pay current bondholders in full thanks to the eurozone backstop.