Debt restructuring or default - Is it enough?

Call it whatever you like, Greece has effectively defaulted on its sovereign debt, atleast half of its private external debt. The agreement that private investors will take a 50% haircut on their bonds constitutes a virtual default. The agreement reached to resolve Eurozone crisis contains this restructuring of Greek debt, a bank recapitalization plan, and an expansion of Eurozone bailout fund.

The agreement to restructure Greek debt also includes a new €130 bn bail-out of Greece by the European Union and the International Monetary Fund and is estimated to reduce Greek debt levels to 120% of GDP by end of the decade. The deal includes a decision to force the continental banks to raise new capital amounting to a total of €106 bn ($150 bn) by June 2012 to raise their Tier I capital ratio to 9% of total capital so as to provide them with greater cushion against potential losses on loans to the PIIGS.

They also agreed to increase the firepower of the remaining amount in the €440 bn ($610 bn) European Financial Stability Fund (EFSF) (estimated to be about €250bn after the proposed new Greece debt deal) by providing "risk insurance" to new bonds issued by struggling eurozone countries, especially Italy. This would limit bondholder losses by guaranteeing a portion of potential losses - EFSF effectively offers credit protection on Greek debt. It is hoped that this would increase the size of the EFSF by 4-5 times to about €1,000bn. Efforts are also on to get outside investors like sovereign welath funds from China, Russia and others.

Though any agreement is welcome, there are several doubts about whether this is a case of too little too late. Critically, even after the haircuts and bailout, Greece will still have a debt-to-GDP ratio of 120% even in 2020. This raises questions about its effectiveness and increases the possibility of more write-downs and bailouts. This would mean complete wiping out of private bondholders and even write-downs by official lenders (who will be the last to suffer any haircuts). Of the 340 billion euros in Greek government debt, only about 200 billion euros is owed to private creditors and therefore covered by the restructuring plan. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring. FT Alphaville has several interesting questions here about the details of the three-pronged bailout plan.

In addition there are more fundamental issues. Eurozone countries' economic stagnation which is driven by a combination of declining economic competitiveness, huge sovereign debts, and difficulty in financing government deficits. The beleaguered peripheral Eurozone economies are handicapped by the unavailability of all the remedies traditionally used by countries facing recession and sovereign debt crisis - inability to indulge in fiscal and monetary expansion, reflate their economies, or devalue their currencies. Though notionally a currency union with a harmonized monetary policy, it does not have any central fiscal authority nor does it have a monetary authority willing to assume its traditional role. In simple terms, Eurozone is a monetary union without a fiscal federation or a full-fledged central bank.

The better placed economies like Germany are strongly opposed to fiscal transfers to bail out their reckless peripheral partners. The European Central Bank (ECB) has refused to lend to its struggling member states. It has preferred to let the newly created and limited European Financial Stability Fund (EFSF) assume the responsibility of lending to those countries and stabilizing the financial markets.

This is in sharp contrast to the policy followed by the US Treasury and the Federal Reserve when faced with similar (some would say, less severe) crisis in late 2008. The Government announced a massive stimulus package to stabilize the economy, while the Fed deployed extraordinary measures to emerge as the lender, buyer and insurer of last resort.

In fact, unlike the US and British bank recapitalization plans in which the respective central banks injected funds directly, the ECB has refused to do so. The banks are therefore relying on private investors to raise their capital so as to reach the 9% level. However, raising money from private investors will be difficult especially given the conditions.

The current conditions call out for proactive central bank leadership. No one seriously disputes that Spain and Italy, currently the biggest concerns, are solvent and are only experiencing a liquidity crisis. Such crises are best averted when central banks step in and open liquidity windows and function as lender of last resort. As Martin Wolf wrote recently, if sovereign default risk is addressed, it will "also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency". See also this excellent paper by Paul De Grauwe. In light of all this, it remains to be seen whether the latest bailout will be effective.

Times, as always, has this nice graphic that captures the three prongs of the bailout plan.



The market reaction has be positive, with Greek CDS spreads nearly halving from 6000 to 3500.