This paper surveys the options now facing the sovereign debtors and their official sector sponsors. It concludes that there are no painless or riskless options.
The eurozone debt crisis is entering its third year. The original objective of the official sector’s response to the crisis -- containment -- has failed. All of the countries of peripheral Europe are now in play; three of them (Greece, Ireland and Portugal) operate under full official sector bailout programmes.
The prospect of the crisis engulfing the larger peripheral countries, Spain and Italy, has sparked a new round of official sector containment measures. These will involve active intervention by official sector players such as the European Central Bank in order to preserve market access for the affected countries.
This paper surveys the options now facing the sovereign debtors and their official sector sponsors. It concludes that there are no painless or riskless options. In the end, the question may come down to this -- to what extent will the official sector sponsors of peripheral Europe be prepared to take on their own shoulders (and off of the shoulders of private sector lenders) a significant portion of the debt stocks of these countries during this period of fiscal adjustment?
Assessing the Options
The official diagnosis of this situation is that it is a footrace; can market access at tolerable interest rate levels be preserved long enough for the benignant effect of fiscal austerity programmes to become visible to the market? If interest rates rise to an unsustainable level before the adjustment programs have had time to do their good work, the race is lost.
Option One (cajole the markets into an act of faith, hope and charity) appears to be ending; perhaps it never really had much of a chance.
Option Two (massage the yields) is about to begin. The OMT programme may work but its fate will turn crucially on three factors that are difficult to handicap. How relentlessly will the markets test the ECB’s resolve to continue buying peripheral bonds in unlimited quantities? Second, how successful will the
ECB be in mollifying the unhappiness of its largest shareholder with the very idea of buying bonds in the secondary market for this purpose? Third, will the economic recovery of the affected countries (and their planned return to normal market borrowing) be delayed by forces beyond their control, a further slowdown in global economic growth for example. This could require the deus ex machina to stay on the stage longer than anyone anticipated.
For two reasons, Option Three (full bailout), if it is tried at all, may not last long. First, the memory of the ill-fated May 2010 Greek bailout is still fresh in the minds of the official sector. Will taxpayer money again be used to repay, in full and on time, private sector creditors, particularly when OSI (official sector involvement, aka restructuring of official sector debt) is in the offing? Second, are there sufficient resources in the European bailout mechanisms to repay all of the maturing debt of the countries now in play over even the next 15 months?
Option Five (a Greek-style restructuring) seems unlikely. In Spain and Italy most of the foreign investors have already exited and been replaced by local financial institutions -- banks, insurance companies and pension funds. A massive haircut to the debt stocks of either of these countries will therefore only decapitate the domestic financial systems. The money saved in debt service will have to be used to recapitalise those institutions.
As Sherlock Holmes might have said, exclude the impossible and whatever is left, however improbable, must be true. That logic leaves Option Four, a debt reprofiling designed to shift maturities out of the adjustment programme period while inflicting the least possible NPV loss on the debtholders.
Let’s be clear: a debt restructuring, even a mild one like a reprofiling operation, is a last resort alternative for most members of the official sector. They may eventually come to it, as they eventually came to it in Greece, but only if all other alternatives show themselves to be financially or politically untenable. Even now, the official sector takes every opportunity to describe the Greek restructuring as “unique and exceptional.”
Notwithstanding this revulsion to a debt restructuring, if one becomes unavoidable the process will be facilitated -- as it was in Greece -- by the high percentage of local law instruments in the affected debt stock. Moreover, the concentration of the paper in the hands of local investors, while it may rule out the more savage debt restructuring techniques, should at least give the sovereign a malleable creditor universe. Local institutions are susceptible to forms of governmental persuasion to which foreigners are immune.
© Social Science Electronic Publishing, Inc.
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