Wednesday, November 14, 2012

The moral hazard with a Greek debt write-down

As the severity of Greece's solvency crisis looms large, calls for writing off atleast a part of the Greek public debt, three-fourths of which are now held by sovereign creditors, has been mounting. Any decision to write off Greece's public debt, especially from sovereign creditors, is likely to have strategic implications at multiple levels. It is not a simple case of a one-time financial write-down, but has moral hazard and expectations forming consequences. There are three immediate implications that come to the fore.

1. How will Greece itself respond to the write-down? More specifically, will it reduce the pressure on Greek politicians to undertake the harsh structural adjustment decisions that are necessary to complement any debt write-down and get the growth back on sustainable path? Greece's is a democracy and its commitment record, even in the past three years, to push ahead with these bitter measures is questionable.

2. How will this be interpreted by the other countries similarly placed and by those who face debt crisis in future? In particular, Ireland, maybe even the other PIIGS? Will this encourage them into following the Greece path? How will this be interpreted by developing countries, atleast some of whom are likely to face similar circumstances in the foreseeable future? The expectations formed by this decision will have consequences for a generation.

3. Most importantly and with immediate implications, what message will sink into the bond markets? In particular, since the longer term prospects of existing debt improves with a partial sovereign debt write-off, will bond markets react by increasing the pressure on the bonds (widening spreads and increasing prices of CDS) of other similarly placed countries, thereby precipitating a deep enough liquidity crisis that would force the EU into another partial write-down. The fact that Italy and Spain, both stand at the precipice, makes this possibility calamitous.

In the final analysis, the strong moral hazard concerns associated with such decisions, make any debt write-downs a deeply strategic decision. Germany's desire to drag the strategic bargaining game with Greece and its creditors as long as possible in the hope of squeezing out as much restructuring commitments (from Greece) and concessions (from investors and creditors) as possible while simultaneously minimizing the moral hazard consequences is therefore understandable. Those criticizing it as mindless is doing more out of despair and hope than after weighing its strategic consequences.

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