Restructuring European debt

By Felix Salmon
December 10, 2010
Barry Eichengreen has a positively crystalline explanation why. It's a first-rate example of economic concepts being explained in plain, easy-to-understand English:

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Are we going to see debt defaults in Europe? Yes—and Barry Eichengreen has a positively crystalline explanation why. It’s a first-rate example of economic concepts being explained in plain, easy-to-understand English:

The more that countries reduce wages and costs, the heavier their inherited debt loads become. And, as debt burdens become heavier, public spending must be cut further and taxes increased to service the government’s debt and that of its wards, like the banks. This, in turn, creates the need for more internal devaluation, further heightening the debt burden, and so on, in a vicious spiral downward into depression.

So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured. Bank debts have to be converted into equity and, where banks are insolvent, written off. Mortgage debts, too, must be written down.

Where I part ways with Eichengreen is here:

The mechanics of debt restructuring are straightforward. Governments can offer a menu of new bonds worth some fraction of the value of their existing obligations. Bondholders can be given a choice between par bonds with a face value equal to their existing bonds but a longer maturity and lower interest rate, and discount bonds with a shorter maturity and higher interest rate but a face value that is a fraction of existing bonds’ face value.

This is not rocket science. It has been done before.

Yes, this has been done before, but I’m not at all convinced it can be done in Europe, even with financial backing from Germany and the IMF.

To oversimplify a bit, there are two different ways you can do a restructuring like this: “market-friendly” and “coercive.” There’s a bit of a grey area between the two, but one way of looking at the difference is that in a market-friendly restructuring, old bonds get swapped directly into new bonds, with the implied threat that if bondholders don’t accept the deal, then the old bonds will simply default and stop making payments. In a coercive restructuring, the old bonds stop paying first, and then that defaulted debt gets swapped into new bonds which actually have a cashflow associated with them.

As a rule, the haircut on a coercive restructuring (think Argentina or Ecuador) is much greater than the haircut on a market-friendly restructuring (think Uruguay or Pakistan).

But in Europe, the necessary haircuts are big, just because the debt ratios are so big. The richer the country, the higher its debt can go before it has to default—and European countries, if and when they default, will be the richest countries ever to do so. What kind of debt-to-GDP ratio would Eichengreen like to see in Greece, say, post-restructuring? Is it even possible to get there with par bonds? (I’m not sure it is.) In any event, it’s hard to see how a “market-friendly” restructuring could do the trick. In order to concentrate bondholders’ minds, you’d need to actually default, rather than just threaten to default.

Because here’s the real crux: no one knows who would win the game of chicken if the European periphery attempted a “market-friendly” restructuring. If bondholders said no, would European governments make good on their threat and go ahead and default, with all the chaos that would imply? The temptation to refuse anything but a very generous offer will be very great, since the moral-hazard trade has worked out so well so many times in the past: in extremis, bondholders always seem to get bailed out.

But given the periphery’s debt levels, a very generous offer isn’t good enough—not even close. Remember that the point of a restructuring is to get countries like Greece to a place where they have regained access to the markets, at sustainable interest rates which don’t result in spiraling debt ratios. I find it very hard to believe that bondholders will ever voluntarily accept a deal which cuts their holdings that much—and I wonder, too, how many of them, upon receiving such a large haircut, would then turn around and start lending to Greece again, on the grounds that hey, its debt ratios look so much better now.

Engineering a successful sovereign debt restructuring in the eurozone, then, is rocket science. It hasn’t been done before, and it might not even be possible. But as Eichengreen shows so clearly, that doesn’t make it any less necessary.

6 comments

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I do agree that a restructuring is inevitable, unless the ECB will monetise the entire Euro-area debt. What intrigues me is what message that sends to other countries, especially developing ones, which are currently servicing their debt. No doubt many of them will scratch their heads and say to themselves: If rich and “respectable” countries like Greece and Ireland can default on their debt, why should we continue to pay? What are the odds of us getting away with a wee bit of a restructuring? Think of what we could finance in the way of election campaigns and other “goodies” if we could save on some of that debt servicing? End result? Vastly increased interest rates for everyone. How do we get out of this nightmare?

Posted by Abulili | Report as abusive

Another fantastic article Felix. I agree that Barry’s explanation is spot on. If you can’t afford debt at your current level of income than you can’t afford debt at a markedly lower income.

One point I would make is that when you say: “in a market-friendly restructuring, old bonds get swapped directly into new bonds, with the implied threat that if bondholders don’t accept the deal, then the old bonds will simply default and stop making payments” that is actually by definition a “coercive restructuring.” The key is the implied threat. Any time an investor is making a decision under government imposed duress than they are being coerced.

What you call a “coercive restructuring” is actually a confiscatory restructuring. When your old bonds get swapped for crappier new bonds or fewer new bonds you were not coerced you were robbed.

Your choice at that point is to move on and accept what the robber has allowed you to keep or try your luck in international court. That process is sufficiently expensive and time consuming that most debt holders take the new bonds and make a mental note not to lend to that country for a few years.

Best hopes for goverments to effectively allocate the resources they have…. and to not allocate resources they don’t have.

Posted by y2kurtus | Report as abusive

Sir,

It is too soon yet for the countries to default. They have to continue to slash spending for another few years.

The critical point will be when their ongoing deficits, sans interest payments, get to zero. That will be the time when governments won’t need the debt markets for new borrowing but only to roll over existing debt. That will be the time they acquire strong bargaining chips.

It is ironic but bond holders must initiate the restructuring now, they shouldn’t wait and risk losing the upper hand.

petar marinov
(san francisco, california)

Posted by rootis0 | Report as abusive

The last comment is an interesting one. It has some merit to it, but it might also be the case that domestic political considerations — these are democracies, remember — will only allow a primary surplus when the countries have been cut off from new funding. Still, it’s pretty clear that, one way or another, any restructuring will be insufficient if the countries can’t maintain a primary surplus.

This might be grasping at straws, but when you mention that “European countries, if and when they default, will be the richest countries ever to do so,” I thought to King Phillip II of Spain. It’s hard to make comparisons across four-plus centuries, but it was a wealthy (by the standards of its time) country that restructured (multiple times) while largely maintaining access to financial markets. One big difference was that the lenders were not distributed; this might actually have made his job more difficult, and the moderns’ less. I’m also not sure how high his debt-to-anything ratios got before he defaulted. His domestic political constraints were certainly different from those of democratic leaders, but he was hardly an absolute monarch, and in many ways his situation might have been close enough.

Posted by dWj | Report as abusive

y2kurtus wrote: “When your old bonds get swapped for crappier new bonds or fewer new bonds you were not coerced you were robbed.”

Nonsense, it is capitalism; these bondholders chose the wrong bond. Why is this different than when someone bought corporate bonds with the corporation later going Chapter 7? If you cannot take the heat, stay out of the kitchen.

Iceland had the right attitude: stuff the banks and holders of debt. Customers will return; they always do.

They only reason this does not happen is that bankers are often very powerful people, knowing many leaders on a personal level. We need leaders with the courage to do the right thing; Angela Merkel is the best we have so far in the EU.

Posted by saucymugwump | Report as abusive

Sir,
I appreciated your article but let me express some distress about the focal point in discussion.
It seems to me that the particular problems affecting european countries right now are quite different among each other: can we talk about a unique sovereign leveraged debt burden ? it´s absolutely clear that debt leverage is not an exclusive euro-periphery problem.
Then a lot of emphasis has being placed on competitiveness and productivity but we should remember that these are long-term goals that must be adressed right now but which entails necessarily delayed results.

Posted by southmed | Report as abusive