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Debt reduction without default?

It is almost a year since commentators began suggesting the idea of a European Monetary Fund. This column, by two of the main proponents, argues that since then the Eurozone has created an emergency funding mechanism, but not a Fund. Europe’s leaders urgently need to take steps towards creating a credible mechanism that can deal with overly indebted countries.

This column proposes a two-step market-based approach to debt reduction. The step by step is presented for readers in a hurry; justification and discussion follow.

Step 1) The European Financial Stability Facility (EFSF) would offer holders of debt an exchange into EFSF paper at the market price prior to that country’s entry into the EFSF-funded programme. The offer would be valid for 90 days. Banks would be forced in the context of the ongoing stress tests to write down even their banking book and thus have an incentive to accept the offer. The ECB would be expected to participate in the exchange and close its programme of distressed government bond purchases (for more on this issue see also Manasse 2011).

Step 2) Once the EFSF has acquired most Greek, Irish, and Portuguese debt, it would assess debt sustainability country by country.

  • If the market price discount at which it acquired the bonds is enough to ensure sustainability, the EFSF will write down the nominal value of its claims to this amount provided the country agrees to additional adjustment efforts (and in some cases asset sales).
  • If under a central scenario this discount is not enough to ensure sustainability then the EFSF might agree a lower interest rate, but with GDP warrants to participate in the upside.

A key condition for this approach to restore access to private capital markets is that the EFSF claims are not senior to the remaining and any new private bondholders. EFSF support must be akin to an injection of equity into the country.

While the EFSF concentrates on the exchange of the stock of bonds the IMF could fund the remaining deficits in the usual way with as bridge financing for the remaining deficits until the fiscal adjustment is completed. The ECB would of course immediately stop its ”Securities Market Programme” as it would lose its primary justification.

A bridge to the future

A year ago we argued that the Eurozone needed a ”European Monetary Fund” (Gros and Mayer 2010). In the meantime the Eurozone has created an emergency funding mechanism, but not yet a “Fund”. European policymakers seem to be reluctant to commit to a major institutional innovation. Yet we believe that a commitment to put in place a credible mechanism to deal with over-indebted countries is now urgently needed. Of course, major institutional innovations take time. Hence, to address pressing issues immediately, we propose a market-based scheme to achieve a substantial reduction in debt for the most distressed sovereign borrowers. This scheme could serve as a bridge to the new EMU architecture from the present conditions, where a combination of a weak banking system and acute sovereign solvency problems creates tensions that require ever more public funds.

Within the present setup, an integrated set of measures is possible and should be taken immediately to reduce uncertainty and restore orderly market conditions:

  • All countries under severe financial pressure, for which markets price a high probability of default, should go under the Eurozone safety umbrella. Most likely, this group would consist of Greece and Ireland, which are already receiving help, as well as Portugal, which is close to being cut off from market funding.
  • All other countries would have to adopt credible policies for successful adjustment so that they retain access to market funding. Presently, the next country in line suffering from a lack of market confidence is Spain. Most economists, including the present authors, would regard market fears of insolvency in Spain as vastly exaggerated. Spain has a relatively low public debt ratio, manageable banking sector problems (confined to the savings and loan segment) and a broadly-based economy with a solid growth potential. Reforms to increase flexibility in the labour market, restructuring in the banking sector and consolidation of finances of regional governments and the pension system would go a long way to reassure investors of the solvency of the public sector. Important steps in the right direction have already been taken on all three fronts, but more could be done. And, more importantly, more needs to be done to restore confidence in the market so that Spain does not face the same problem as Ireland (ever-mounting losses in the banking system).
  • The EFSF should offer to exchange the outstanding debt of the countries under the safety umbrella against its own obligations at the market price before the countries come under the umbrella. The exchange would thus be different from a market purchase, which in a narrow market might drive prices quickly up and thus allow for little savings.
  • When the debt exchange has been completed, the EFSF would negotiate with the debtor country a reduction in the nominal value of the debt against an additional adjustment effort. The reduction in debt could be equal to the discount paid by the EFSF, thus implying no direct expense for Eurozone member countries (but of course they would be taking a risk).

Issues with implementation

  • Discount: Assuming an average maturity of bonds from Greece, Ireland, and Portugal of roughly five to seven years, an average coupon of 4.5% and a yield to maturity of 8%, the average implied haircut priced by the market would seem to be between 20%-25% (somewhat higher for Greece, but lower for Portugal). Given that the total outstanding public debt of these countries in nominal terms amounts to about €650 billion, investors would have to write off about €130 billion to €160 billion, which would represent about 10% of the total capital base of the European banking system if one assumes that three-quarters of these countries’ debt is held by banks.
  • Risk for EFSF: The EFSF (or rather Eurozone member states) may be left with an exposure of some €490 billion to €520 billion. This is a large, but not intolerable risk burden for the Eurozone countries. Assuming as a worst case that the fundamental value of Greek, Irish, and Portuguese debt is only 60% of their GDP (or around €340 billion), the maximum loss Eurozone countries could suffer would be around €180 billion. Taking this risk would undoubtedly be painful, but, at an exposure of little more than 1.5% of Eurozone GDP, it should be considered an acceptable price to pay for the stabilisation of the euro (or rather its financial markets).
  • Bank debt: When bank debt becomes public debt, the assets of the banks also become public assets. Whether or not bank rescues increase public debt is thus essentially a question of the quality of the assets on the books of the banking system. This is a key point for Spain and Ireland, whose experience has shown that asset quality can deteriorate quickly (or simply be misjudged at the outset). This is why we recommend a large programme of asset sales for Ireland and Spain to reassure investors on this point. The governments and banks in distress usually cling on to the illusion that the true value of their assets is much higher and resist asset sales with the argument that a “fire sale” does not allow them to realise this “true”, long-term value. However, it will be very important to allow as many as possible foreign investors to undertake a due diligence of these assets so that they can form their own opinion. The market will trust the results of such a process much more than the ever changing numbers that regulators and accountants put into the balance sheets of the troubled banks in Ireland and Spain.
  • External debt: Public debt that is owed to domestic residents can in principle always be served because it represents just a transfer within society, and could be financed for example through a capital levy on deposits or other tangible assets (of residents). The key point here is that for some countries external sustainability should not be a problem, even if their public debt is very large. In reality, only for Greece and Portugal does our preferred measure of foreign debt (the cumulated current account) exceed 60% of GDP. For Greece net foreign debt is approximately equal to four-fifths of the net public debt of the country. For Portugal foreign debt is about 30% higher than public debt. But for Ireland most of the debt is domestic since the foreign debt of the country is only one-fifth of the public debt. This implies that the rough calculation made above of the risk taken by Eurozone countries as creditors of the post-exchange public debt of the three countries represents, if anything, an upper bound of the risk taken by the EFSF.
  • Funding requirements: Financing this debt exchange would require an increase in the size of the EFSF, although in principle the resources already committed amount to €560 billion (headline funding of the EFSF €440 billion, plus the EFSM of €60 billion plus the €60 billion already earmarked for bilateral credits to Greece), which would be sufficient to cover all three countries (i.e. sufficient to acquire 100% of the outstanding public debt at the average discount mentioned above).
  • Seniority: The ultimate aim of any debt reduction scheme is to allow the debtor to regain access to capital markets. Given that Portugal, Ireland and Greece will still have a high public debt after any market-based reduction, this will be possible only if the Eurozone partner countries are willing to take the same risk as private creditors. If official credits were made senior, the average cost of debt for the debtor country concerned would not fall when it receives official financing since there will be a corresponding increase in the cost of private funding.
Would it be enough?

Our calculations show that a country like Greece could live with a debt-to-GDP ratio of around 120% of GDP, and a rather low trend growth rate of nominal GDP (say 3%), provided the interest rate is not much above 4%. In this case the even a primary surplus of “only” 4% of GDP (achieved by Greece in the past and below what has been maintained by other EU countries with strong fiscal adjustments, see Alcidi and Gros 2010) would send debt/GDP on a declining path.

Retaining limited liability

Having dealt with the emergency, a new Eurozone architecture can be constructed which enshrines the lessons learnt from the current crisis. What is needed in our view is a further step towards economic integration and some risk-sharing of Eurozone countries while still preserving the character of Eurozone as a “limited liability company”. Our proposal for a European Monetary Fund made a year ago would fit this bill.

Debt buybacks have been analysed, and dismissed in the literature prompted by the long drawn out LDC (as they were called then) debt crisis of the 1980s (see Bulow and Rogoff 1988 and Krugman 1988). We are aware of the basic arguments of this literature, which assumes both that markets evaluate default probabilities properly and that official financing is senior. In our proposal the second would not be the case. If the market is right the EU (or rather the EFSF) would thus have taken a risk (albeit limited as calculated above). There is also a question of consistency – all the European institutions involved (Commission, Council, EFSF and ECB) insist that the probability that the adjustment programme in Greece fails is zero. If this is indeed the case there is no reason to charge an extra risk premium.

Only the future can tell whether the market expectations are wrong. In the run up to monetary union the sceptics in the market were proven wrong. But one has also to admit that in the case of Greece this would be the third time, after its accession to the EU against the opinion of the Commission and its entry into the Eurozone with questionable public finances, that the country has been given the benefit of the doubt.

References and recommended reading

Alcidi, C and D Gros (2010), “The European experience with large fiscal adjustments”, CEPS Commentary.

Borensztein, Eduardo and Paolo Mauro (2002), “Reviving the Case for GDP-Indexed Bonds”, IMF Policy Discussion Paper, PDP/02/10, IMF, September.

Buchheit, Lee and Mitu Guti (2010), “How to Restructure Greek Debt”, mimeo.

Bulow, J and K Rogoff (1988), “The buyback boondoggle”, Brookings Papers on Economic Activity, Brookings Institute.

De Grauwe, Paul (2011), “A less punishing, more forgiving approach to the debt crisis in the eurozone”, CEPS Policy Briefs 230.

Eichengreen, Barry (2010), “Ireland’s rescue package: Disaster for Ireland, bad omen for the Eurozone”, VoxEU.org, 3 December.

Gros, Daniel (2010a), “All together now? Arguments for a big-bang solution to Eurozone problems”, VoxEU.org, 5 December.

Gros, Daniel (2010b), “The seniority conundrum: Bail out countries but bail in private, short-term creditors?”, VoxEU.org, 5 December.

Gros, Daniel (2010c), “Adjustment Difficulties in the GIPSY Club”, CEPS Working Document No. 326.

Gros, Daniel and Thomas Mayer (2010), “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund”, VoxEU.org, 15 March and CEPS Policy Brief, 11 May.

Gros, Daniel and Thomas Mayer (2011), “Debt reduction without default?”, Policy Brief No. 233, CEPS, Brussels 11 May.

Krugman, Paul (1988), Market-based debt reduction schemes, NBER Working Paper 2587.

Manasse, Paolo (2011), “Unilateral restructuring, buybacks, and euro swaps: An example”, VoxEU.org, 5 February.

Miyamajima, Ken (2006), Hot to Evaluate GDP-Linked Warrants: Price and Repayment Capacity, Working Paper 06/85, IMF.

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