Tuesday, November 3, 2015

The challenge with early restructuring of debts

Indebtedness and deleveraging have been an important global economic concern in recent years. Several Eurozone countries, none more than Greece, suffer from massive debt burdens. The Chinese economy is struggling on the back of heavily indebted corporates and local governments. Closer home in India, the fate of "House of Debt" companies are just a more high-profile reflection of broader corporate indebtedness. In all three cases, creditors, primarily banks, are the obvious counterparties suffering the losses. 

There is little prospect of any satisfactory denouement to this problem. Worse still, the policies being followed do not appear to be doing much good. Currently, in all these cases and more, the strategy has been to reschedule loans in the hope that with time recovery will take hold and deleveraging will happen through growth. This assumes that the debt troubles are essentially a liquidity problem - either firms have illiquid assets or the asset revenue streams are further in time - and not one of solvency. 

But what if the latter were true? What if a large proportion of the underlying assets have negative values and the debts cannot be serviced under any circumstances? This assumes significance since it is now widely accepted that the Greek debt burden is just unsustainable and increasingly evident that the same is the case with Chinese local governments and many large infrastructure projects in India. In this case, rescheduling would not only be kicking the can down the road but also increasing the final tally of losses - interest, cost escalation, partial default provisioning etc. In the circumstance, the best approach would be to strip shareholders and have creditors take haircuts. 

Economists have accordingly advocated that the Eurozone debts should have been restructured with haircuts and forgiveness. In fact, economists like Ken Rogoff argue that the Great Recession should have been countered with not just quantitative easing but more importantly, policies that nudged governments into buying back risky debts and lenders into writing-off some part of their loans. The conventional wisdom is that this is an ideological battle between those advocating the wait-and-watch and restructuring strategies. 

Maybe, but for the political decision makers, there is another important consideration. Governments would find it difficult to offer taxpayer's money to bailout bad investments and their respective promoters, investors and lenders. The lurking feeling would be that these reckless and greedy stakeholders are being bailed out. Also baked into this dynamic is the moral hazard associated with bailing out bad investments. 

A bailout becomes possible only when the costs of the stand-off become egregiously damaging to the economy. A settlement, with losses imposed on the stakeholders, then becomes politically less unacceptable. 

Accordingly, though many of the stressed projects are insolvent and cannot be revived without haircuts and contract renegotiations (extend tenure or raise tariff or viability gap funding), it is unlikely to happen till something definitive happens. This includes the developer defaulting completely or going bankrupt, or creditors offering haircuts, or the cumulative drag of all the projects on the sector becomes unbearable. Till then, the promoters and creditors invariably hold out, in the expectation that things will improve or the government will blink. 
Not only would the total cost of a final settlement be much higher, the private benefits from the bailout would outweigh the private costs due to the delay for all the private stakeholders. Coupled with the taxpayer-financed bailout, everyone is left worse off,  similar to a game of Prisoner's dilemma with its inevitably sub-optimal outcome. This is the insurmountable transactional challenge with political and social bargaining in any such situations. 

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