Euro-Area Redenomination Risk and the Gold Clause Cases
This is a joint post by Mitu Gulati and Mark Weidemaier.
Odds seem to be against a Marine Le Pen victory in the French presidential election, though a victory by Emmanuel Macron is hardly assured. And there continues to be chatter about redenomination risk in Europe, to the point that, according to a recent Deutsche Bank estimate, even short-term German bonds were factoring in a 5% risk of redenomination. Last week, in our class on international debt finance, we discussed the so-called Gold Clause cases from the 1930s. Though ancient history in some respects, the cases offer important lessons for some of the debates regarding redenomination risk. First, though, some background.
In simplified form, the Gold Clause cases involved challenges to the Congressional abrogation of contract terms indexing a borrower's payment obligations to gold. The clauses, which appeared in both corporate and government bonds, were designed to protect against inflation. With respect to U.S. government bonds, the clauses theoretically constrained the government's ability to use monetary policy to reduce its debts. The analogy to the Euro area should be fairly clear, except that in the Euro area the constraint is structural rather than contractual: no individual government controls monetary policy. During the deflationary days of the Great Depression, the U.S. government wanted to pursue inflationary policies, but the gold clauses were a barrier that threatened to bankrupt many companies, if the not the government itself. For more detail, there are very interesting papers by Gerard Magliocca, Randall Kroszner, and Kenneth Dam.
Long story short: The U.S. Congress passed a law abrogating these gold clauses, prompting legal challenges to the law as it applied to both corporate and government debt. The Supreme Court had a relatively easy time upholding the law as it applied to corporate debt, given the government's broad authority over the value of money. But the Court had a much harder time evaluating the abrogation of gold clauses in the government's own debt, ultimately ruling (in Perry v. United States) that the abrogation was unconstitutional. But then, in a truly bizarre bit of legal reasoning, the Court ruled that there was no remedy--indeed, no real damages--since the government had effectively banned transactions in gold.
Why is this relevant to Euro area redenomination risk? One reason is that many Euro area governments have issued bonds with contractual protections against redenomination. As we wrote a while back on FTAlphaville, these collective action clauses (CACs) require the approval of a super-majority of bondholders to change the currency of payment. But the protection CACs seemingly offer bondholders is undermined by the fact that the bonds are governed by the issuing government's law. The lesson offered by the Gold Clause cases--reaffirmed by Greece in 2012--is that bonds governed by the issuer's own law are never immune from restructuring.
Put differently: just as lenders who lend in the borrower's own currency assume currency risk, those who lend under the borrower's own law assume legal risk. Contract clauses designed to protect against the former do not protect against the latter. Notwithstanding the CACs, then, the French government could change its laws to dramatically impair the value of bonds. Conceivably this could take the form of abrogating the CACs and their protection against redenomination. But such an aggressive approach would be both unnecessary and contrary to investor expectations. Instead, the government might impair the ability of bondholders to sue for non-payment, impose a tax on payments received by bondholders, or change its laws in other ways adverse to bondholders. Even the threat of such actions might be enough to win super-majority approval of a change to the currency of payment.
We wouldn't go so far as to say that the CACs in Euro area bonds are worthless, as John Dizard seems to argue in the Financial Times. We doubt that a government would want to show such complete disregard for contract terms as to try to abrogate the CACs and then change the currency of payment by fiat. The need to negotiate with investors holding such bonds implies that the government might offer a small premium in order to win the super-majority approval necessary to change the currency of payment. Or, to put the point in terms of litigation dynamics: in lawsuits challenging any redenomination, holders of CAC bonds would have a somewhat stronger legal position than holders of non-CAC bonds, and this might translate into a slightly higher settlement value. But in a bond governed by local law, we agree that contract protections offer little value. This, more than anything else, is the lesson we take away from the Gold Clause cases.