Why Europe’s periphery should restructure their bonds

By Felix Salmon
January 18, 2011
its leader gives the strongest case for biting the bullet now. And Mohamed El-Erian has now officially signed on:

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The drumbeat for debt restructurings on Europe’s periphery is becoming too loud to ignore. The Economist has now come out strongly in favor; its leader gives the strongest case for biting the bullet now. And Mohamed El-Erian has now officially signed on:

You do not solve a debt problem by adding new debt on top of old debt. Yet it seems that European officials are fixated on this approach…

More people are recognising that the time has come for another approach – what this week’s Economist magazine calls “Plan B”. This involves the orderly restructuring of some European sovereign debt on terms that allow a meaningful chance of re-accessing markets in future at sustainable rates. This would be accompanied by measures to enhance growth prospects in highly indebted European countries; ring fence the other, fundamentally sound economies; and push banks and other institutional holders of restructurable debt to raise prudential capital.

The FT article El-Erian links to quotes all manner of other private-sector actors, including Citigroup chief economist Willem Buiter, saying that there will inevitably be several euro area sovereign debt restructurings over the next few years. And if there’s one thing that everybody can agree on, it’s that if you’re going to restructure your debt, it’s always better to do it sooner rather than later. And, as the inimitable Lee Buchheit says, the European Stability Mechanism, if enacted, will make any future restructuring much worse for private-sector creditors:

In a euro area restructuring, ESM loans, junior only to those from the IMF, would enjoy preferred status as well, leaving bondholders to shoulder more of the losses from mid-2013 onwards.

That has scared some investors. “It’s like telling a fellow that you won’t shoot him until after lunch. He was never going to enjoy the shooting, but now you have also spoiled his lunch,” says Lee Buchheit, a sovereign debt restructuring specialist at law firm Cleary Gottlieb Steen & Hamilton.

All of which makes Paul Krugman’s big NYT piece on Europe very well timed. He clearly lays out how we got to where we are, and what the four different paths are that the Eurozone could follow from here: along with the debt-restructuring approach, there’s also “toughing it out”, which basically entails painful deflation, recession, and fiscal austerity in much of the eurozone periphery; and the two extreme corner solutions in Europe — either the peripheral countries leave the euro entirely, and probably devalue too, or else the currency union becomes a fiscal union, and the debts of any one country get covered by all member states.

Liz Alderman has a good report in the NYT about the serious problems with the “toughing it out” approach, which Europe is attempting to follow at the moment. And so some economists, like Dean Baker, are pushing Krugman’s “Revived Europeanism” approach — fiscal union, essentially — saying that it “would essentially be costless right now”.

Politically, however, it’s a much harder sell, especially in Germany. And it would also require a level of confidence about Europe’s economic future which I don’t think anybody has right now. And as the Economist leader notes, even the debt-restructuring path will involve a serious fiscal hit for Europe’s wealthiest countries:

All creditors, including governments and the European Central Bank, will have to chip in. New rescue money will also be needed: to fund defaulting countries’ budget deficits; to help recapitalise these countries’ local banks (which will suffer losses on their holdings of government bonds); and, if necessary, to recapitalise any hard-hit banks in Europe’s core economies. The ECB and others should stand ready to defend Belgium, Italy and Spain if need be.

To use a US analogy, the choice facing Europe right now is whether to deal with its peripheral nations like Frannie, like AIG, or like General Motors.

The Frannie approach means a fiscal union: their debts are our debts. The AIG approach is the current “tough it out” one, where the hoped-for outcome is that a solvency crisis can be solved with liberal applications of government liquidity. But that only happens when you have strong growth — share-price growth in the case of AIG, with lots of expected future profitability, or economic growth in the case of countries like Greece, Portugal, and Ireland. And right now it’s impossible to see how a country like Greece can possibly grow its way out of its debt trap.

Finally, there’s the GM approach: restructure the debt, and get back onto a long-term sustainable footing. It’s harder for countries than it is for companies. But it might well be the least-bad option, by some large margin.


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Not sure restructuring is in Europe’s (including “core Europe’s”) economic interest at the moment. The current uncertainty keeps the Euro relatively low, while the “bail-out costs” to core Europe of said uncertainty are reasonably bearable: Funding costs remain low, they have seniority in repayment over private creditors, and even the overall amount per country is manageable at present. Restructuring now would immediately require “stabilisation funding” of periphery countries and many banks by those same countries, higher interest rates in the short term, and eventually lead to a strengthening of the Euro (all of post-restructuring Europe, based on both competitiveness and debt/GDP ratios, would compare favourably with the US). Whereas now the lower Euro is essential to economic recovery of peripheral Europe, and certainly helps Germany and other core Europe countries a great deal in their export-driven economic growth. Meanwhile, as long as the fiction has to be maintained that peripheral Europe will eventually honour all its debts, they are under huge pressure to restructure their economies and improve competitiveness – something that would be less than assured if they restructured now (vz. Argentina). Finally, imagine the future of political decision makers in Europe, including the ECB, if they decided to restructure now – non-existent. So, as long as it’s not in Europe’s economic and political interest to restructure, they will not.

Posted by Abulili | Report as abusive

Now that El Erian has positioned PIMCO properly, the good doctor issues his instructions. That’s the kind of alpha worth paying for.

The ones worthy of our contempt are not the PIMCOs of the world, but slimy politicians who deliver too much that is not paid for. Across the pond we know their kind well as they leave their trail of goo from the local county council to the halls of Congress and the White House.

Posted by DanHess | Report as abusive

Germany should be happy about that there are several over-leveraged countries using the euro. If it weren’t for those countries, the euro would probably be worth $2 right now, and how much would Germany be exporting then?

They can complain that it’s not fair that other countries are spending too much, but it’s not like Germany will have to make the most sacrifices as part of any belt-tightening or debt restructuring. Maybe if they imported more stuff from their currency partners, those partners would be in better shape, and wouldn’t be so broke. But then the euro would be more expensive, and Germany’s export machine wouldn’t look so damn impressive.

I’m not the guy who said people should be careful what they wish for, but it sounds like good advice.

Posted by OnTheTimes | Report as abusive

Restructuring ( effectively cancelling) peripheral country’s debts will ensure that structural reforms are relaxed and that they go back to their bad old ways. The PIGS are still living beyond their means and have weak populist governments who will only enforce the necessary cuts if the ECB / IMF are looking over their shoulder. Greece, Ireland and Portugal in particular need several years of cutbacks, a rebalancing of their public / private sector economies and a return to a standard of living that is affordable and sustainable. Restructuring now would only postpone the inevitable and they will be back, cap in hand, for another loan. They need to become more competitive and this can take two forms – leave the Euro or endure years of deflation.

Posted by paulos | Report as abusive

“You do not solve a debt problem by adding new debt on top of old debt. Yet it seems that European officials are fixated on this approach” – As it appears so is the US administration.

Posted by OdieWoofDog | Report as abusive

Ireland Wields Stick to Wound Bank Bondholders

Irish Finance Minister Brian Lenihan is about to inflict more pain on bank investors. Unless they take it, analysts say worse may follow.

Junior bondholders in Dublin-based Allied Irish Banks Plc will decide this week on an offer to buy back more than $5 billion of subordinated debt at 30 percent of face value. Analysts at BNP Paribas SA recommend investors accept the package or risk getting “the stick” after the government passed laws allowing it to reduce payments to bondholders.

http://bit.ly/hsktnX (Bloomberg)

Posted by polit2k | Report as abusive