Sunday, November 21, 2010

Can there be such a thing as an “orderly” restructuring?

As EU and IMF officials set about to negotiate their second rescue package to a eurozone member in a year, more and more voices are calling for the “orderly restructuring” of peripheral countries’ debt as an integral component of a crisis resolution framework.

The idea is that, when the debt dynamic is unsustainable under most doable fiscal consolidation scenarios, pouring more official money into the problem amounts to “kicking the can down the road” rather than begetting a permanent solution.

A key advocate of this view has been Nouriel Roubini, who in a recent paper called for an “orderly, market-based approach to the restructuring of Eurozone sovereign debts” to deal with any insolvencies now, avoid the deferral of tough choices later and contain moral hazard.

My objective here is not to challenge the “kicking the can down the road” argument, which is of course correct. Neither am I going to discuss whether Greece , Ireland or, indeed, Italy are illiquid or insolvent. Instead, I want to examine whether it is at all possible to achieve the “orderly” restructuring that Nouriel and others propose in the specific case of the eurozone.

The focus on the eurozone matters: It is not particularly constructive, nor relevant, to evoke (as Nouriel does) the experiences of Pakistan, Ukraine, Uruguay or the Dominican Republic in order to shed light on what might happen if Greece or Ireland decided to “bail in” the private sector. These countries’ GDP is tiny, and so was the debt they restructured. To give you an idea, Pakistan restructured $608 million (with a “m”), the DR $1.5bn, Ukraine $3.3 billion and Uruguay around $5.5bn 1/. Greece ’s $420bn of public debt is far more prone to a disorderly outcome by virtue of its size and also due to Greece’s association with other fiscally vulnerable eurozone members.

Second, manageable initial debt-to-GDP ratios in those countries meant that sustainability could be achieved with only a small NPV reduction: Per the IMF, the NPV reduction was just 2% for the DR, 5% for Ukraine and 8% for Pakistan. In Uruguay, which had a comparable (though still smaller) debt-to-GDP ratio to Greece’s 133%, the NPV reduction was 13%. But I should point that Uruguay achieved fiscal surpluses of the order of 3-4% immediately, rather than 3 years into the IMF program, which is what is envisaged for Greece (IF ever feasible).

Let's also note that where the necessary NPV reduction was large (Argentina: 75%; Russia: 44%), the restructuring was not exactly an “orderly” one—and neither was it pre-emptive.

So much for the precedents. What can we say about the potential for an orderly restructuring in the eurozone today? First, let’s define what we mean by orderly, which, in my view, requires three elements:

1) Participation should be largely voluntary. A high degree of investor coercion can lead to a larger number of hold-outs that makes the process lengthier and messier. More importantly, a precedent of coercion in one eurozone member could prompt wary investors to stampede out of other vulnerable members, turning one country’s crisis into the self-fulfilling eurozone domino everyone dreads. This potential for contagion (through trade and financial linkages and/or by association) cannot be overstated when talking about eurozone members in my view.

2) The restructuring, along with the policy mix adopted by the debtor country, should restore debt sustainability under reasonable macroeconomic scenarios. It should also help achieve a prompt return to market financing.

3) The NPV reduction in the debtor country should not shift the crisis elsewhere in the eurozone (e.g. via the banking system).

Clearly these elements are usually conflicting—and more so in the eurozone. For a largely voluntary restructuring, the NPV reduction offered must be attractive compared to the alternative. In this context, Nouriel suggests that a restructuring be “market-based” (ie reflecting the going market value of the debt): after all, with Greece’s long-term bonds already trading at 50-something cents on the dollar, investors should voluntarily accept a 40-50% NPV reduction and do so in an orderly way, right?

In my view, such a “market-based” offer is not at all a guarantee for an orderly restructuring. First, because the “market value” can change swiftly once restructuring becomes a certainty (see what happened to peripheral spreads once Angela Merkel began to talk about bail-ins). Second, the threat of contagion cannot be overstated. What looks like a sustainable debt level in Spain (or Italy ) today might not be tomorrow, if the market decided to turn its attention there.

Third, many of the holders of the debt are banks that have yet to mark-to-market their sovereign debt holdings. Here, Nouriel’s proposal is an exchange offer that preserves the debt’s face value but prolongs the maturity and reduces the coupons. This would surely help these banks avoid immediate write-downs and the concomitant capital adequacy problems; but it would also “lock” their balance sheets with assets they cannot sell for years to come (unless they are ready to take the losses), preventing them from using their capital to lend to the productive sector. This might be “orderly” from a short-term financial-stability perspective, but it’s certainly suboptimal for the eurozone’s growth outlook.

So under what circumstances can we then have an “orderly” restructuring in the eurozone? In my view, a “pre-emptive” and “orderly” restructuring is only possible if the likes of Germany and France are ready to provide a credible commitment to backstop all the fiscally vulnerable eurozone members either directly (through a generous fiscal transfer that helps achieve debt sustainability) or indirectly (through an explicit capital backstop to their own financial sectors, which are the main holders of peripheral debt).

Note that I am *not* calling for a pre-emptive restructuring for Portugal, Spain or Italy here; nor am I talking about the establishment of a European Sovereign Debt Restructuring Mechanism or Credit Resolution Mechanism which, as Nouriel argues, is not necessary. I am talking about a credible and comprehensive backstop to cover the losses of any necessary debt restructuring, across the board, by the financially stronger governments.

Such a backstop might be anathema to the Germans, but the economic case for holding their nose and plunging into the “cesspool” can be compelling: German banks’ exposure to the PIGS (“I” for Ireland ) is around $500 billion (BIS data); that of French banks is around $400bn. This sets a clear ceiling as to the potential liability borne by the taxpayers if the crisis is contained to the PIGS.

In contrast, in the event of a piecemeal approach that leads to a systemic crisis, the size of their taxpayers’ burden becomes indeterminate: Not only will the likes of Italy be vulnerable (talking about “systemic”); but the negative wealth effects from a collapse of Europe’s financial markets would be extremely adverse for the growth outlook, especially as the global economy is still at a very fragile state.

Bottom line, it is wishful thinking to talk about an “orderly” debt restructuring when that involves a piecemeal, country-by-country approach that leaves the rest vulnerable to speculative attacks. It is also wishful thinking to talk about “market-based” approaches, given the flimsy nature of market values and the implications for the health of eurozone banks. An orderly restructuring is indeed achievable, provided it is backed by a credible backstop by the financially stronger governments. It is also desirable: the alternative won’t be pretty for anyone…

1/ Source: “Cross country experience with restructuring sovereign debt and restoring debt sustainability”, IMF 2006

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