Adventures with reprofiling, Lee Buchheit edition
It’s always illuminating to sit down with Lee Buchheit. He’s the dean of sovereign debt restructuring, he’s living through by far the most interesting period of his career right now, and this week I got the rare opportunity to ask him a bunch of questions on the record. Argentina, sadly, was ruled off-limits, but that just meant we had more time for Europe, where Buchheit was very, very interesting.
The Reuters TV crew has put the headline “Sovereign debt 101 with Lee C. Buchheit” on this one, which suffers a bit on the truth-in-advertising front: it’s a high-level discussion, and it helps to have a pretty sophisticated understanding of what has happened in Greece, Portugal and Ireland; and also to have read Buchheit’s recent paper with Mitu Gulati, “The Eurozone Debt Crisis — The Options Now”.
In that paper, Buchheit puts forward a novel idea for what Spain and Italy should do if they lose market access at acceptable yields: they should basically do the mother of all can-kickings, and restructure their debt by pushing every bond’s maturities out by five years.
But before we talked about that idea, we talked about Greece, which Buchheit said was pretty much unique in the annals of sovereign debt restructurings in that it was not designed to get the country’s debt load onto a sustainable footing. And as in many ways the primary architect of that deal, he should know.
Buchheit’s point, and it’s a good one, is that Greece was never in control: it basically just always did whatever it was told to do by the official sector. For a good two years after the country lost market access, the official sector told Greece that it must not default on its debts, and instead provided all the money to repay those debts in full and on time — on top of all the money needed to finance Greece’s fiscal deficit. Then, suddenly, the official sector changed its mind, and demanded a private-sector haircut. So, that’s what Greece did. But even after a steep haircut, Greece’s debt is still unsustainable. Which raises the question: what is the official sector going to do about that, and when is it going to do it?
Buchheit’s answer — and I think he’s right about this, at least so long as Greece remains in the euro — is that eventually the official sector will be forced to do a reprofiling, or “treatment”. They’ll avoid taking a nominal haircut: they’ll keep the principal amounts intact, which won’t do any favors to Greece’s debt-to-GDP ratio. But they’ll push maturities out very far indeed, and attach extremely low coupons to them, to minimize the debt-service burden on Greece.
There are massive problems with this, however, not least the fact that I can’t imagine how Greece could ever regain market access under such a regime. Buchheit thinks the same thing: “Greece could not, I think, return to the voluntary markets even if you did stretch out the official sector debt until the 12th of never.”* If it stays in the euro and doesn’t reduce the face value of its official-sector debt, private-sector participants will have no real interest in funding the deficit. What Buchheit is talking about here isn’t a strategy, so much as it’s the absence of a strategy: it’s almost literally the least that the official sector can do. And even then it’s not going to happen until after the German elections in September 2013.
And there’s another problem too. If Greece gets its official-sector debts reprofiled, then Ireland and Portugal are going to want exactly the same thing. Private-sector debt defaults have large costs; official-sector debt reprofilings do not. And so if the official sector does do this for Greece, they’re going to have to find the wherewithal to do exactly the same thing in Portugal and Ireland. Which won’t be cheap or easy.
If reprofilings are unattractive things to the official sector, they’re much more unattractive to the private sector, which considers them to be a default. So why would Italy and Spain ever consider such a thing with their private bonds?
Buchheit’s answer is that Spain and Italy can’t do a Greek-style restructuring of their domestic debts, with a principal haircut, because that would just render their entire domestic financial systems massively insolvent at a stroke. The resulting bank bailout would cost more than the amount saved on the national debt, making the whole exercise a false economy.
What’s more, such an exercise would put a lot of foam on the runway, as the crisis-management types like to say. As we saw with Argentina, a default which everybody sees coming is actually a lot less damaging, from a systemic perspective, than a default which happens suddenly. (Argentina’s slow train-wreck had much less impact on the markets generally than did Russia’s smaller, but much more unexpected, default, and one of the big problems with the Lehman bankruptcy was the fact that it was unforeseen by the markets.) The exercise of reprofiling Spain and Italy’s debts would give the markets notice that something a bit more drastic might have to happen in five years’ time — and with that kind of advance notice, both the official and the private sectors would have a lot of time to prepare for such a thing.
Finally, Buchheit points out that when it comes to the eurozone, countries always end up doing what the official sector wants, rather than what private-sector bondholders want. And there are lots of reasons why the official sector would like a reprofiling — the biggest of which is that it doesn’t involve the official sector being forced to bail out the private sector. The official sector would still need to fund the countries’ deficits, but at least it wouldn’t need to fund their private-sector principal repayments as well.
There is one more possibility, which Buchheit largely dismisses — and that’s the break-up of the euro. He says, quite rightly, that the euro has brought many benefits to the peripheral countries — but it seems to me that the era of those benefits is largely over, and that we’re now entering an era where the costs are becoming unbearable.
The problem with Buchheit’s reprofiling idea, whether it happens to official-sector debt in Greece and Portugal and Ireland or to private-sector debt in Spain and Italy, is the same as the problem with the Greek debt restructuring: it doesn’t address any of the big problems of a heavily-indebted uncompetitive country with sky-high unemployment. The technocrat’s answer to such problems is always the vague-sounding “structural reforms”, but in most of these countries, I don’t think that “structural reforms” are either politically or practically feasible. Sometimes, huge problems require drastic solutions. And the most drastic solution for a troubled eurozone country is, clearly, a default and devaluation. Which could be quite attractive, if it came with some one-off official-sector financing (to protect depositors), as well as continued membership in the European Union.
*Update: Buchheit emails to clarify that “if indeed the official sector were to stretch out their claims against these countries to the 12th of Never at a very low coupon, I suspect that the markets would be prepared to resume lending. In effect, by virtue of the maturity dates, the official sector will have subordinated itself to new (short and medium term) private sector lending.”