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.

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