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The pitfalls of EZ sovereign debt restructuring

Newly named Greek PM Lucas Papademos wrote this Vox column on 26 October 2011 on the Greek debt problem. He argues that the most effective and prudent way to reduce Greece’s debt burden is to implement the July agreement, reinforced by ‘firewalls’ to protect financial institutions and avoid contagion. Both require a substantial increase in EFSF ‘firepower’. Bank recapitalisation is necessary, but not sufficient.

As the Greek debt crisis has escalated, the calls for restructuring the country's public debt have correspondingly increased. Debt restructuring is advocated in order to lighten Greece's debt burden, ensure the sustainability of its public finances and improve the economy's long-term growth prospects. In addition, it is argued that debt restructuring resulting in losses for bond holders, mainly financial institutions, would reduce the risk of moral hazard created when countries that had previously pursued irresponsible fiscal policies receive official financial support.

Such arguments are valid, but incomplete. They fail to take into account the substantial costs and risks associated with a restructuring process. A more comprehensive analysis reveals that the likely net financial benefits from debt restructuring, in terms of reducing the size of Greece’s public debt and the cost of servicing it, would be much smaller than often envisaged, while the adverse consequences and potential risks – both for Greece and for the Eurozone as a whole – are likely to be significant, with profound and far-reaching implications for financial stability and economic performance.

The net financial benefits of sovereign debt restructuring by a Eurozone country that leads to losses for bond holders due to a haircut in the nominal value of outstanding debt depend crucially on two factors:

  • First, the distribution of sovereign debt across creditors and the extent to which they would be able to absorb such losses without government support, and

  • Second, the funding constraints and financial interlinkages stemming from the functioning of the European monetary union and the integration of financial markets.

The structure of Greek sovereign debt by bond holder implies that the net financial benefits from restructuring are considerably smaller than frequently suggested or expected. At the end of July 2011, the nominal value of outstanding Greek central government debt was €366 billion. About €104 billion, almost 30% of the total debt, and more than a third of the debt in the form of bonds and short-term securities, were held by Greek residents, mostly banks, pension funds and insurance companies. At the present juncture, a substantial reduction in the nominal value of the Greek debt held by these institutions, partly valued at par and not marked-to-market, would have to be largely offset by government financial support in order to recapitalise banks and strengthen the financial position of pension funds and other entities.

It is likely that markets would require the reinforcement of Greek banks' capital positions by a larger amount than the haircut in the nominal value of sovereign debt, especially in the case of a big writedown on their assets, in view of its potential impact on confidence and effects on the real economy. If the writedown on bank assets is very large, the required recapitalisation of banks by the Hellenic Financial Stability Fund could effectively result in their temporary nationalisation, further reducing the value of assets of pension funds with sizeable holdings of bank shares. In any event, the Greek government would have to provide substantial support to pension funds, which have already seen the market value of their assets, including equities and real estate, drop drastically over the past three years. In addition, losses sustained by other domestic holders of public debt (households and non-financial firms) would have implications for economic activity and tax revenues. Thus, the net financial benefits for the Greek state from a restructuring of the debt held by residents and the associated net reduction in public indebtedness are likely to be small, even without taking into account the indirect effects on Greek public finances of the impact of debt restructuring on bank liquidity, credit provision, and economic activity.

Another large share of outstanding Greek government debt is held by official institutions. At the end of July 2011, Eurozone governments, the International Monetary Fund, the European Central Bank, and other official institutions held about €118 billion1 or almost a third of Greek government debt. For fundamental institutional, political, and legal reasons, there can be no debt restructuring resulting in losses burdening these official debt holders. It is inconceivable that Greece will not fully service and repay its official debt and thus inflict losses on the taxpayers of its European partners who have provided support during the crisis. Such an outcome would also be incompatible with the Treaty that prohibits EU member states to bail out other member states by assuming their debt obligations. The financial support given to Greece, as well as to Ireland and Portugal, by other Eurozone countries is in the form of loans and guarantees and thus does not involve ‘fiscal transfers’, provided of course that these official loans will be fully repaid.

Furthermore, it can also be argued that a sovereign debt restructuring by a Eurozone country should not entail any losses on that country’s government debt that had been purchased by the ECB for the purpose of improving market functioning, facilitating the transmission of monetary policy across the Eurozone, and protecting financial stability. Potential losses on the sovereign debt held by the ECB resulting from debt restructuring would have to be fully offset eventually by the country concerned, both for reasons of principle and because of their ultimate impact on the other Eurozone countries’ public finances.

It follows that only the restructuring of the €144 billion, or 40% of the total Greek government debt, which is held by foreign private investors, would bring net financial benefits (by reducing the country's debt size and servicing costs). If we exclude loans, treasury bills, and other short-term securities, the holdings of Greek government bonds by foreign private investors that could be restructured are about €136 billion.2 Hence, a 50% haircut in the value of this part of the debt would reduce the total debt by €68 billion, or by 19%.3

This net financial benefit for the Greek state from a large nominal debt haircut should be assessed against the additional costs and the various risks – both for Greece and the Eurozone as a whole – that will be associated with debt restructuring. Thus, the overall net gain would be smaller.

The adverse consequences for Greece of a ‘hard’, involuntary debt restructuring leading to forced losses for bond holders – essentially a sovereign default – will go well beyond the costs arising from recapitalising domestic banks and supporting pension funds. The effects of a sovereign default on confidence, the liquidity of the Greek banking system – which already faces serious funding problems – and the real economy, are difficult to predict and quantify, but they are likely to be substantial and should not be underestimated. Such effects would also undermine the fiscal consolidation process, especially if the debt restructuring causes a credit crunch and adversely affects economic activity. The ECB, which currently provides Greek banks with liquidity approaching €100 billion, will not accept as collateral securities that would have been downgraded to default status. It would thus be necessary to provide ‘credit enhancement’ so as to improve the quality of this collateral at a cost that would ultimately be borne by the Greek government. Moreover, following a hard debt restructuring imposing a high haircut and leading to sovereign default, Greece’s access to capital markets will become remote and more costly.4

Under the present circumstances, the most serious risk stemming from a sovereign debt restructuring of a Eurozone country is to the financial stability and the economic performance of the Eurozone as a whole, due to the increased likelihood of widespread and significant financial contagion and of spillover effects from sovereign debt markets on Eurozone banks. Events over the past two years, especially since July 2011, have clearly demonstrated that the risk of financial contagion and spillovers on banks, which some had claimed would be limited and could be contained, can actually be significant and far-reaching. Its implications for the balance sheets of European banks, as well as for the public finances and economic activity of a growing number of Eurozone countries, have become more visible and sizeable.

The magnitude of financial contagion and its effects on the Eurozone banking system, credit provision, and economic activity will be much greater than can be inferred from the exposure of financial institutions to the sovereign debt of an individual country. The probability and impact of financial contagion is augmented by the adverse feedback between sovereign bond markets, the banking system, and the real economy as well as by the unfavourable confidence effects and market expectations that are likely to accompany a sovereign default. The recent sharp increases in sovereign bond yields in the Eurozone have been sending loud and clear warning signals – first, the option of hard debt restructuring and sovereign default should not be pursued; and, second, there is an urgent need to address in a credible and comprehensive manner the increasing systemic risk to Eurozone financial stability emanating from the turmoil in sovereign debt markets.

At the 21 July Summit, the Eurozone leaders and EU institutions agreed to support a new economic adjustment programme for Greece and fully cover the country’s financial needs together with the IMF and the involvement of the private sector (PSI). The latter would include a voluntary exchange of bonds through a menu of options, implying on average a net present value loss of 21% for private bond holders, and a debt buy-back programme, partly financed by the European Financial Stability Facility (EFSF). Nevertheless, the estimated NPV loss of about 20% for private sector bond holders and the net contribution of the PSI by €50 billion (including the contribution of a debt buy-back) have been considered insufficient for ensuring debt sustainability, also in the light of recent economic and market developments. A larger haircut would also reduce official financial support and the risks for taxpayers, while at the same time penalising financial institutions for past imprudent credit policies. It has thus been proposed to increase the haircut to be applied, that is the NPV loss in the PSI debt exchange, to 50% or even more.

The preceding analysis and risk assessment imply that the marginal benefit in terms of additional debt reduction would be relatively modest, while the adverse economic consequences and financial stability risks would be significant both for Greece and the Eurozone. Specifically, given the structure of the Greek sovereign debt by holder and the July PSI agreement, an increase in the haircut rate from about 20% to 50% could result in a reduction of Greek public debt by about €15-20 billion, that is by about 4-6%. The actual amount of debt reduction would, of course, depend on the chosen PSI options, features, and parameters.5 But it is doubtful that such additional debt relief would be achieved with the voluntary participation of the private sector, or would be assessed to be so; thus it could result in a sovereign default and a credit event. In addition to the implications of such an outcome for Greece as summarized above, its potential effects on bond yield spreads and CDS premia for other Eurozone countries that are perceived as fiscally vulnerable would lead to large – possibly huge – aggregate losses for financial institutions and the other holders of those countries' sovereign debt.

At the current juncture, the most effective and prudent way ahead is to implement the 21 July Summit agreement, appropriately reinforced. A major strengthening of firewalls to protect financial institutions and a convincingly substantial increase in the firepower of the EFSF are needed to address the ongoing pressures in the sovereign debt markets. The recapitalisation of European banks is definitely necessary, but it will not suffice to resolve the Eurozone debt crisis. It is also essential to effectively increase the financial resources of the EFSF and enhance its operational flexibility.

The agreement reached concerning the private sector's involvement in financing Greek debt should be essentially preserved. It could be amended in order improve debt sustainability, taking into account recent economic and financial developments, and address the political concerns that have been raised, by changing the parameters of certain options, restricting their number and possibly increasing the contribution of the buy-back operations. Debt relief would also be increased if the PSI contribution also included the Greek government bonds maturing beyond the end of 2020. But any amendment of the July PSI agreement should be made very carefully so as to strike the right balance between debt reduction and voluntary private sector participation; it should avoid the pitfalls and perils of a hard, involuntary debt restructuring and it should not lead to a credit event. Indeed, in the case of sovereign default, the strengthening of the banks’ firewalls and EFSF’s firepower would have to be substantially greater to protect financial stability.

There are no free lunches for debtors and no easy solutions for creditors. Political leaders and policymakers are faced with difficult tradeoffs between potential benefits, costs, and risks. An involuntary restructuring of the Greek sovereign debt is likely to effectively result in relatively modest net financial benefits (net of the costs related to bank recapitalisations, credit enhancements, other forms of financial support, and its effects on bank liquidity and economic activity) and pose substantial risks that would seriously threaten the financial stability and economic performance of the Eurozone as a whole. The realisation of these risks would ultimately impose a heavier burden on European taxpayers, have undesirable consequences for the stability and cohesion of the Eurozone and undermine the credibility of the euro. For all these reasons, a comprehensive and convincing policy package that can help restore market and public confidence is urgently needed for the resolution of the European debt crisis.

Editor’s note: A shorter version of this article was published in the Financial Times on 21 October 2011.


Cruces, JJ and C Trebesch (2011) ‘Haircuts and the cost of sovereign default’, VoxEU.org, 13 October.


1 This figure does not include the official loans disbursed since the end of July 2011.

2 The figure of €136 billion of Greek government debt held by foreign residents is conceptually different from the estimated gross private sector involvement (PSI) contribution of €135 billion to the financing of Greece over the period 2011-2020. The gross PSI contribution is derived, by assuming a 90% participation rate, from the nominal (face) value of €150 euro of government bonds maturing before the end of 2020, held by both Greek and foreign residents.   

3 The share of debt held by both Greek and foreign residents that could be restructured would actually be smaller if the additional official lending provided after the end of July 2011 is taken into account.

4 Recent research provides empirical support for this view. See Cruces and Trebesch (2011).

5 This estimate is based on the 21 July PSI schemes and parameters. It also incorporates alternative estimates about the expected cost of the necessary recapitalization of Greek banks and the financial support to pension funds, but excludes the cost of the required credit enhancement to improve the quality of the collateral that Greek banks could pledge to the ECB. It does not take into account the indirect effects on public finances of a credit crunch that could follow a sovereign default.


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