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SOVEREIGN AND SUB-SOVEREIGN DEBT DEFAULTS UNDER FIXED EXCHANGE
RATES: A MARKET BASED SOLUTION
Mohammed Dore and Roelof Makken
Brock University
DRAFT VERSION: OCTOBER 30, 2015. NOT FOR CIRCULATION: PLEASE DO NOT QUOTE
© Mohammed Dore and Roelof Makken
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ABSTRACT:
Sovereign debt defaults under fixed and flexible exchange rates continue to occur even when there are
implicit, explicit or perceived guarantees. In this paper we are concerned only with debt within
jurisdictions that have fixed exchange rates. The institutional framework for defaults has some
shortcomings compared to corporate debt defaults. But attempts to set up mechanisms have either
failed or the proposals are too complicated, involving constitutional change. The objective of this paper
is to propose a market based solution, where the outcomes are speed of resolution, avoiding moral
hazard, being preventative, ensuring reduced risk of collapse of banking system, and accelerating hope
of recovery and return to some steady state equilibrium. We propose that sovereign and sub-sovereign
debt be divided into three tranches. The first tranche of sub-sovereign debt, up to some limit, would be
secured by some supranational entity; this would be clear from the bond prospectus. The second
tranche would be debt for collateralized infrastructure assets, so that in the case of a default, creditors
would acquire the underlying assets. The third tranche would be all unsecured sovereign debt when the
country exceeds pre-set guarantee percentage, for example as when the debt/GDP ratio target in the
Maastricht Treaty is exceeded. Thus in a steady state equilibrium, all sovereign debt would conform to
these categories, and risks would be priced by the market. However when a country’s debt is out of
equilibrium, a transition path back to steady state equilibrium is required. We indicate one possible
transition for Greece. We show that when the financial institutional structure is incomplete or
inadequate for debt defaults (as is the case for the EU), reliance on the market is not only possible but
also preferable. The only precondition for a market-based solution is that an informational asymmetry
be eliminated. This asymmetry is a missing market with a profit making opportunity, which can be
filled by debt-rating agencies.
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Introduction:
Sovereign debt has a long history and debt defaults have occurred in all continents. In Europe,
virtually all countries have defaulted at some time or another. A partial alphabetical list of
European debt defaults is shown in Table 1.
Country
Albania
ArchduchyofAustria
AustrianEmpire
Austria-Hungary
Bulgaria
Croatia
Denmark
France
Germany
GermanState:Hesse
GermanState:Prussia
GermanState:Schleswig-Holstein
GermanState:Westphalia
Hungary
Greece
Hungary
TheNetherlands
Poland
Portugal
Romania
Russia
Spain
Sweden
Turkey
Ukraine
UnitedKingdom
Yugoslavia
DefaultinYear(s)
1990
1796,1802
1805,1811,1816
1868
1932,1990
1993-1996
1813
1812
1932,1939,1948
1814
1807,1813
1850
1812
1932,1941
1826,1843,1860,1893,1932,2015
1932,1941
1814
1936, 1940, 1981
1828, 1837, 1841, 1845, 1852, 1890
1933
1839,1885,1918,1947,1957,1991,
1998
809, 1820, 1831, 1834, 1851, 1867, 1872,
1882, 1936–1939
1812
1876, 1915, 1931, 1940, 1978, 1982
1998–2000, 2015
1822,1834,1888–89,1932
1983
Table 1: Partial List of European Debt Defaults
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Modern sovereign debt crises are mainly associated with the plight of developing countries, and
many researchers have analyzed both the causes of the crisis and the consequences. For example, see
Oine,1983; Armstrong el al., 1984; Moreno, 1985; Niehans, 1985; Chakravarty, 1987; Watkins, 1986;
Zloch-Christy, 1987; Tarshis, 1987; Avramovic, 1985; Khans, 1984; Davidson, 1987/88; Levitt, 1988,
and Dore and Tarshis 1990. Sometimes countries have been forced to accept restructuring of debt,
and sometimes a large portion of the debt has been written off. The Baker Plan (Cheng 1985), failed
and it was replaced by the Brady Plan, which achieved its objectives of restoring growth to Latin
America (IMF 2003).
The European sovereign debt problem also has an extensive literature. One good example is the symposium in
the Journal of Economic Perspectives, summer 2012. In particular, in this issue, Philip Lane (2012) gives a clear
exposition of the causes and possible remedies for the European sovereign debt crisis. There have also been a
number of proposals to set up a credible mechanism for restructuring the debt of a defaulting nation
(see, Anne Krueger, 2002). Professor Krueger returned to the topic with co-authors in an
interesting paper issued by a new European think tank called Bruegel (see Giavanti et al. 2010) In
this paper, the authors Gianviti et al recommend the following two -step process to set up a
mechanism to deal with European sovereign debt defaults: a procedure to initiate and conduct
negotiations between a sovereign debtor with unsustainable debt and its creditors leading to, and
enforcing, an agreement on how to reduce the present value of the debtor’s future obligations in
order to reestablish the sustainability of its public finances. This would require a special court to
deal with such cases. For European cases, the Court of Justice of the European Union would be the
natural institution for this purpose and a special chamber could be created for that purpose.
In the second step, rules for the provision of financial assistance to euro-area countries would be
agreed upon. Should a euro-area country be found insolvent, the provision of financial aid should be
conditional on the achievement of an agreement between the debtor and the creditors re-establishing
solvency.
In part inspired by this proposal, the European Union, set up a temporary agency for supplying
financial assistance; this agency was called the European Financial Stability Facility (EFSF).
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Subsequently the EU has set up a permanent agency called the European Stability Mechanism, which
took over the older loans of the EFSF. Lending by the permanent EFSF/ESM could also be provided,
under appropriate conditions, to euro-area countries facing temporary liquidity problems. The ESM
has provided assistance to Portugal, Spain and Ireland. But its aid to Greece has not been at a scale
required to manage the debt problem, as shown below.
Section 1
Sovereign defaults and debt restructurings have been very common in the past. In this paper, we
focus mostly on the defaults of the past two centuries with greater emphasis on the most recent ones.
History on sovereign debt defaults offers a wide range of cases, explanations of the causes of the debt
difficulties and approaches to resolving the issues. Understanding sovereign debt risk, default and
resolution is of major significance for policy makers. Fortunately, during the past decade we have had
relatively few sovereign debt incidents. Argentina (with its own currency and Greece ( with a fixed
exchange rate being in the euro zone) have had to deal with their outstanding debt. They are still trying
to resolve creditor issues and structures to prevent future problems. Both countries have received a lot
of attention for their economic woes. The resolution of their debt problems appears to be taking an
extraordinary amount of time.
Of particular interest is an examination of the default of ‘sub’-sovereigns. Typically we refer to
sub-sovereigns as the level of government below the national or central government. In our analysis we
have extended the definition of this category by including countries that have given up their monetary
sovereignty. It is important to keep in mind that defaults that occur at the sub-sovereign level can
potentially cause contagion for the other sub-sovereigns in that monetary or constitutional space, as
well as for the central or federal government. Also, explicit, implicit and perceived guarantees should
be taken into account. From a credit perspective, careful analysis is needed to recognize the risks and
liabilities associated with entities that are explicitly or implicitly guaranteed, or even more critical,
having perceived guarantees. In Canada, the Canadian Mortgage and Housing Corporation is explicitly
guaranteed, whereas Fannie Mae and Freddie Mac in the US were implicitly guaranteed. The US
government took financial responsibility for these two US entities when they failed during the Great
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Recession that started in 2008-9. In 2009 the Irish government’s finances were severely compromised
when the authorities provided the financial backstop for its national banking system. In Europe credit
spreads for the individual member states were remarkably tight relative to other federal jurisdictions
around the world, such as the Canadian provinces. There was the perception that the weaker members
of the EU would be assisted in case of a crisis.
The history of the public finances of the US may be instructive in this regard. In the period
1840-70, 15 US states defaulted, representing half the US state debt. Courts supported the creditors, but
it now seems that sovereign borrowers appear to have immunity and it is extremely difficult for
creditors to recover all the debt, once a state encounters difficulties in servicing the debt. The
repudiation of the US state debts made subsequent US borrowings in Europe virtually impossible. The
US federal government did not bail out the states. This decision of the Federal government was very
different from its decision after winning the revolutionary war against Britain in 1783, when the US
central government assumed the debts of the 13 states. It was seen as a way of unifying the country.
During the 19th century the states were given more fiscal independence and hence responsibility for the
care of their own public finances. But trouble with their state debts resulted in US legislation
prohibiting states from issuing bonds covering operating budget shortfalls. The US experience is
instructive as to how precarious public finances of individual states can be, particularly when such
states have no influence on monetary policy, and hence cannot rely on currency devaluation. Clearly
Europe is not alone in experiencing difficulties in developing a framework for intra-government debt
issuance and default resolution.
Defaults occur with great frequency. The apex of sovereign default was during the mid-1930s
when about 40 % of all sovereign issuers were in default. To illustrate the frequency and magnitude of
sovereign defaults, Figure 1 is instructive.
Figure 1: Sovereign External Debt: 1800-2006
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In recent years there have been few sovereign debt defaults or restructuring issues. Before discussing
possible frameworks for default restructuring and resolution, it is critical to understand the main
reasons as to why debt crises occur.
To b sure, external and/or internal forces may be at play. External forces, which are beyond the
government’s control, are such factors as rapidly changing commodity prices, rising global interest
rates and economic difficulties experienced by a trading partner, all leading to a rapid change in the
economic performance of the country and its ability to pay the interest on the debt or repay the loans.
Internal forces can be controlled by the government, usually with fiscal policy. However at times a
government may be forced to stabilize the banking sector from collapse and be stuck with a huge
financial burden. There are ways to minimize the odds of default. Most important of all is the term
structure of the debt outstanding. Long term debt, and well spaced-out maturity schedules will reduce
the roll-over risk. Respecting prudent debt/GDP ratios is also important. There is no shortage of
guidelines (e.g. the Maastricht Treaty) and studies (Reinhart/Rogoff) on this topic(REF ). Based on the
Mundell-Flemming models, it is evident that in a fixed exchange rate environment, it may be
particularly attractive to pursue an expansionary fiscal policy, as it will not lead to crowding out.
However, the government could experience increased volatility on its credit spreads. An increase in the
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credit spread is a market based reminder of the perceived increase of risk and a refection of the
disapproval of the current fiscal policies and accumulated debt levels of the country in question.
The cost of default can be very high. Empirical evidence (REF pg 48SZ) indicates that the cost of
default and or debt restructuring to the debtor is greater than the original shock. Moreover, default
involves a ‘deadweight loss,’ which should be minimized. The cost to the debtor is greater than the gain
for the creditor. The restructured bonds should have features that align the interests of the debtor with
those of the creditor; e.g. the restructure bonds could be linked to GDP performance, or reflect real
returns to the bond holder. The debtor may have difficulty accessing capital markets again, incur
reputational risk or encounter sanctions. Its financial system will also be affected. (REF SZ pg 50).
Sturzenegger (REF 04) estimates that a defaulter that also experiences a banking crisis will have an
output loss of about 4.5% below trend for 5 years. Also, international trade will suffer as was
demonstrated by Rose (REF 05) and Spiegel (REF 04). The decline in bilateral trade may linger for 15
years and amount to 8% of GDP. After a default, the country will experience in higher credit spreads.
Last but not least, there is a high risk of contagion, where other weaker jurisdictions may be deprived
from accessing the capital markets, and hence experience the same fate.
The existing institutional framework for debt restructuring and default resolution leaves much
to be desired. It appears to take a lot of time, generates uncertainty and delays the potential for
economic recovery. Yet, there are several examples of speedy resolutions to debt crises, allowing
countries to re-emerge more rapidly with strong economic growth and brighter prospects for its people.
It is therefore of the essence to review the institutional framework, to explore ways to improve the
system and to advocate a solution. Advancing new ideas is essential, given the enormous deterioration
in the public finances as a result of the Great Recession of 2008-10 and hence the reduced fiscal
flexibility to counteract any future unfavorable events. Not resolving the current lax state of the
sovereign debt resolution mechanism, will leave the global economic system at risk in case of a wave
of defaults, and create the prospect of “lost decades”.
Providing clarity in the debt contracts is of the essence. The historical approaches to dealing
with the sovereign defaults are no longer appropriate or desirable. In the past, it was not uncommon for
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creditor nation governments to deploy harsh diplomatic measures, impose loan sanctions, install
collectors or, in extreme cases, use force to penalize the debtor nations. None of these approaches are
helpful in creating conditions for a recovery of the debtor nation.
When sub sovereign debt default occurs, there is little possibility of collecting through the
courts as the sovereign debt issuers have immunity, at least in the US under the Eleventh Amendment
(Johnson and Young 2013). However a state can explicitly waive its immunity in a bond issue, as some
US states have done.
Prior to 1945, many bond issues had arbitration clauses. Interestingly the bond community has
stepped away from this. This remains inexplicable. Bond issuing governments have a preference not to
have bond arbitration clauses included in the prospectus, as any specific mention of default in the
prospectus is likely to raise the level of concern around the possibility of default with potential bond
investors, and hence lead to higher interest rates. Moreover, governments have a preference to work
through their own court system. In fact it may allow them to give preferential treatment to local
bondholders in case of default. Bondholders may have preference as well for the court option as there is
a wide body of jurisprudence, and scope for individual deals. Instructive in this regard, may be the
current New York case of the Argentine hold-out investors, or ‘vulture funds’. Many vulture funds
have had an adverse impact on the defaulting countries and vulture funds have made huge gains ( REF
UN document).
During the first seventy years of the 19th century settlements were time consuming, taking on
average 14 years, mostly due to the lack of coordination on the part of the creditors. In response, the
British decided to establish the British Corporation of Foreign Bondholders (BCF) in 1870, with a
significant organizational adjustment in 1896. The idea was to collect the information on the debtor
countries and coordinate the creditors in order to facilitate a debt resolution. There was hardly scope for
any legal actions post resolution. The BCF can be credited for reducing the duration of a typical default
resolution to six years.
At the end of the 1970s the Bank Advisory Committee (BAC) was established. It was an
attempt to incorporate a new approach to international finance, which was more driven by the money
centre banks. The BAC was international and universal, versus the BCF that had been very national in
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scope. In other words the BAC represented all investors, and not just those of a certain nation. By the
early 1980s unanimity was needed on the deals made through the BAC. Stragglers were able to cause
some significant delays but in general, quick resolutions were achieved; in fact many of them within a
few months. This meant in many cases big write-downs for the creditors.
In the late 1980s a new approach was tried to reduce the negative impact of defaults on money
centre bank balance sheets. It was the advent of the Brady bond. Bank loans were converted into
tradeable securities. It meant a haircut (reduction in the NPV) for the banks. This often took the form of
term extensions. Debtor nations were asked to embark on adjustment programs. Special
‘enhancements’ were added to the securities to protect the investors in Brady bonds from future default.
It opened up the credit markets for the debtors. The structure reduced the balance sheet pressures for
the money centre banks by creating liquidity for their assets and reducing the risk of a credit crunch.
Investors in the new Brady bonds were given special enhancements, often in the form of a minimum
guarantee.
With the rise of increased home ownership in the US, it was no longer just the money centre
banks owning sovereign bonds. The owners of government bonds have become quite an eclectic group,
from Italian retail investors to Wall Street based hedge funds, and from pension funds to vulture funds.
In short the number of players has increased significantly and with each bondholder type, an increase in
the type of settlements they would accept.
The successful approaches of the past may no longer be appropriate. The IMF mandate is to
ensure smooth functioning of the international financial system. To this end attempts were made to
avoid debt crises and find speedy resolutions. Some key concepts and tool kits were developed to
determine a debtor nation’s capacity to pay, conditional lending etc. In short, the IMF was most helpful
in setting parameters for a ‘fair’ debt resolution. However, there were concerns that the IMF might be
favoring the banks, was slowing down the real resolution through superficial adjustments and was
creating the impression of public sector bail out. In some cases the IMF reputation may have been
compromised as it played the role of adjudicator, while at the same time being one of the creditors.
Early this millennium the IMF proposed the Sovereign Default Resolution Mechanism (SDRM) in
2001. However, they were not able to obtain acceptance from the stakeholders.
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Other venues considered for arbitration are ICSID (International Center for the Settlement of
Investment Disputes), UNCITRAL (United Nations Commission on International Trade Law) and
special bilateral arrangements through bi-lateral investment agreements. Only the former has some
appeal. UNCITRAL is much more trade related, and not that relevant for most bond and credit issues.
A bi-lateral agreement is limited in scope, given the internal diversity of the investor base in sovereign
bonds. The scope to use bilateral agreements and membership in ICSID is limited at best. Both are
appropriate for foreign direct investment disputes. Some academics have suggested that there may be a
role for ICSID (REF Giffen & Farren), and that it could provide a potential alternative to the domestic
courts, provided that ICSID had the authority to adjudicate sovereign debt disputes. The key criteria in
order to be relevant to ICSID are currently not aligned with the nature of a bond issue. The term
investment has a very specific meaning and can be derived from the ordinary meaning of investment,
preparatory works, subsequent practice, arbitration awards, and doctrine (REF MW pg 209). There is a
strong element of time commitment for the investment.
If debt default resolution has to occur in the domestic courts, could the argument be made that
domestic bankruptcy laws should be deployed? Unfortunately, it is not that simple. Domestic
insolvency procedures are not relevant to sovereign defaults. A corporation does not have the option of
repudiation; there is the doctrine of sovereign immunity and the concept of “odious debt.” But there are
some major aspects can and should be explored.
The US system of Chapter 11 (for corporations) and Chapter 9 (for municipalities) protection
may be useful. Under Chapter 11, a trustee (an independent party) is responsible for monitoring the
business as a going concern as the debtor in possession is still running the organization. The trustee is
responsible for the necessary reports, and the establishment of a creditors’ committee consisting of the
largest unsecured creditors. The debtor in possession has typically 120 days to file a recovery plan. If
the exclusivity period is exceeded, the trustee may present a competing plan. Key strengths of the
Chapter 11 protection are that there is an independent trustee (an arbitrator), a time line and access to
interim financing. Moreover, it allows the debtor to re-structure, allowing for recovery while being
protected from interference by the creditors. The creditors’ exposures are tabulated and their interests
coordinated by the trustee. All unsecured creditors get treated similarly. Of course secured creditors
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will have recourse to their collateralized assets in case of bankruptcy and liquidation. The domestic
bankruptcy procedures are designed to allow the firm to restructure, to work within a tight timeframe,
to enforce a predetermined priority structure and to bring the financial issue to a constructive end.
In 1934 the US enacted municipal bankruptcy legislation, in the form of Chapter 9. The
legislation was designed in such a way as not to interfere with the sovereign powers of the states. The
legislation is to protect financially distressed municipalities from the creditors. Again, the municipality
is allowed to bring forward a reorganization plan. The role of the bankruptcy court is more limited than
in the case of Chapter 11. Critical are the sensitivity and the legality surrounding sovereign immunity.
In summary, the critical success factors for resolving distressed financial issues are an independent
adjudicator, the formulation of a recovery plan by the debtor, a clearly defined timeline, the
coordination of creditors and no room for post resolution legal action.
Institutional reforms at an international level appear difficult. Yet action is needed. Before
considering a possible market-based solution, consider a steady-state equilibrium, in which there are
three types of bonds. First, there is the best quality sovereign debt that is sustainable and the issuer is
trusted. A debt would be judged to be sustainable, it is was not “excessive”, or was within some
prudent measure such as not exceeding 60% of GDP of the country. Let us classify such debt as the
“Tranche 1”. The yields on Tranche 1 bonds will be typically low. Next consider bonds that are
secured in some way, such as infrastructure bonds with the underlying asset as collateral, or where
there is an explicit CDS to cover default. The rating agencies will in all probability rate such debt as top
quality, but there may be some variance in the ratings, depending on the perceived risk assessed by the
rating agency. Call such bonds “Tranche 2.”
All other debt that does not belong to the above 2 categories will be “mezzanine” debt, of debt
that belongs to Tranche 3. This debt would carry much higher yields and buyers of such debt must bear
the risk of a default. Over time, some debt that was classified as Tranche 1 might fall out of favour, if
some prudent ratios were exceeded due to new economic conditions. In such an eventuality some debt
could migrate from Tranche 1 to Tranche 3.
The above sketch of sovereign debt in equilibrium, assumes no missing information, as all
information that is of value will have a market value. This thought experiment is akin to a rational
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expectations equilibrium, in an Arrow-Debreu contingent claims model, there are no missing markets
and no informational asymmetries; in such a model all profit-making opportunities are exhausted. In
practice, in the sovereign debt market we see asymmetric information on credit worthiness and ability
to service the debt. But a diligent credit agency could overcome this problem and carry out the
necessary “debt sustainability analysis” and market such information to all potential bondholders. Once
this informational asymmetry was eliminated, the sovereign debt market would function as if in
equilibrium, with only new information triggering adjustments, which restore equilibrium.
Thus when new information arises there is a disequilibrium situation. With orderly bond
market classification and correctly estimated risks, an orderly transition back to equilibrium, through
the market mechanism, becomes feasible. Such a transition is described for Greece in Section 4 below.
The transition to equilibrium will be market driven, once the missing information is eliminated and
there are firms, or rating agencies that will rate all sovereign debt in accordance with debt sustainability
criteria, which take into account risk of default. Indeed their debt sustainability analysis would be
similar to that of the IMF, which takes risk into account (IMF 2003).
With the market-based approach, the objective is to provide enhanced transparency, incentivize
proper governance and accounting, provide clarity to the investors, accelerate debt restructuring in case
needed, avoiding moral hazard, be preventative, reduce the risk of the collapse of the banking system
and most importantly increase the possibility of economic recovery for the country.
In equilibrium, all sovereign debt will fall into three tranches of debt. This will allow for
increased transparency, and will take advantage of the market segmentation in the bond market. Having
segmented debt instruments will facilitate alignment of the interests of the issuer with the investors.
We add some further detail. Tranche 1 debt will be debt that has been issued to cover operating deficits.
These bonds will form the bedrock of the reserves of the banking system; for instance this kind of debt
will meet the Basel III requirements; it would also be attractive to other low risk tolerant investors.
Tranche 2 would be for debt that has been accumulated to build infrastructure. The bonds will be
collateralized with specific infrastructure assets. It will facilitate investment in infrastructure. In case of
default, the investors can put claims on the underlying assets. In case of a distressed sale of the asset,
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the government would be able to determine the timing of the asset sale and not be selling the assets at
the bottom of the business cycle, which is now sometimes the case in restructuring proposals.
Tranche 3: debt that has been accumulated beyond a certain norm, such a debt to GDP ratio. For
Tranche 3 debt, or Mezzanine debt, there would be no guarantees, no recourse lending. In case of
default, this segment of debt will be subject to loss in the form of a “haircut.”
SECTION 4: THE TRANSITION TO EQUILIBRIUM FOR GREECE
The EU is not a federation like the USA or Canada, of for that matter like Germany or Mexico. The
most integrated component of the EU is the Eurozone group of 19 countries that use a common
currency, namely the euro. The EU has limited fiscal capacity; its budget is based on country
contributions of 1.25% of the GDP of each of the 28 countries, or about 200 bn euros a year. Its
financial agencies are still in the process of being formed. At the height of the financial crisis, the EU
had set up a temporary agency called, the European Financial Stability Facility (EFSF). As mentioned
earlier, in October 2012, it was replaced by the European Stability Mechanism, based in Luxembourg.
The ESM has a capital of euro 700 bn; its major capital contributors are Germany (27 %), Italy (20%)
and Spain (18%); but so far its paid-up capital is small at 80 bn euros. It raises its money by borrowing
in the international capital market. The maximum it can lend is 500 bn euros. The amount money owed
by Greece to the EFSF/ESM is euros 141.9 bn. The maturities for this debt is well staggered, as shown
in Figure 2. According to Wolfgang Proissl, Chief Spokesperson for EFSF/ESM, the Greek debt would
be manageable even if Greece was once again in default in the future.
Furthermore, the EFSF/ESM does not face any liquidity shortage as a result of Greek actions. Up
until 2023, the country is only obliged to pay small amounts to the EFSF/ESM, because interest rate
payments and redemptions on the biggest part of the EFSF loans to Greece have been deferred by 10
years. Even if you assume that Greece fails to honour its interest rate and redemption obligations to
the EFSF, eurozone member states would only have to jump in with funds from 2023 through 2054,
the year when the last EFSF loan tranche falls due. If Greece defaulted on this debt, then eurozone
member states would split up the Greek obligations among themselves, according to their share in
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the ESM and over a more than 30-year time span. This means that the annual budgetary impact for
each country concerned would be quite manageable. However the Total Greek Debt is 331.4 bn
euros, as shown in Table 2.
Table 2
Note that this total debt as a ratio of EMU GDP is only 3.3 %. And 67.6% of the total debt of
euros 331.4 billion is held by 3 countries: Germany, France and Italy.
CouldtheESMassumemoreoftheGreekdebt?InAugust2015,Greecesigneda
MemorandumofAgreementforafurther41bneuros(tobepaidinstages)mainlyforbank
capitalization.Greecewilltargetamedium-termprimarysurplusof3.5%ofGDPwithafiscal
pathofprimarybalancesof-0.25%in2015,0.5%in2016,1.75%in2017and3.5%in2018tobe
achievednotablythroughupfrontfiscalreformssupportedbymeasurestostrengthentax
complianceandfighttaxevasion.TheprojecteddebtrepaymentscheduleisshowninFigure2.
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Greecewillundertakeanambitiousreformofthepensionsystemandaprogramofprivatization
ofgovernmentassets,aimedatensuringdebtsustainability.Whilefurtherassistanceispossible,
theMOUexplicitlyrulesoutdebtforgiveness.ToquotefromtheAugust2015MOU:
“The analysis concludes that debt sustainability can be achieved through a far-reaching and
credible reform programme and additional debt related measures without nominal haircuts.
In line with the Euro summit statement of 12 July, the Eurogroup stands ready to consider, if
necessary, possible additional measures (possible longer grace and repayment periods)
aiming at ensuring that Greece's gross financing needs remain at a sustainable level. These
measures will be conditional upon full implementation of the measures agreed in the ESM
programme and will be considered after the first positive completion of a programme review.
The Eurogroup reiterates that nominal haircuts on official debt cannot be undertaken. The
analysis concludes that debt sustainability can be achieved through a far-reaching and
credible reform programme and additional debt related measures without nominal haircuts.
In line with the Euro summit statement of 12 July, the Eurogroup stands ready to consider, if
necessary, possible additional measures (possible longer grace and repayment periods)
aiming at ensuring that Greece's gross financing needs remain at a sustainable level. These
measures will be conditional upon full implementation of the measures agreed in the ESM
programme and will be considered after the first positive completion of a programme review.
The Eurogroup reiterates that nominal haircuts on official debt cannot be undertaken.”
(Emphasis added)
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Table 3: Greek Debt Greater than 9 bn euros and paid-up capital shares of 8 EMU Countries
Greek Debt in
Percent of GDP
Euros (>9 bn)
Share (%) of
Share (%) of
ESM Paid-up
ECB Paid-up
Capital
Capital
Germany
92.0
27
18
France
70.3
20
14
Italy
61.5
18
12
Spain
42.3
12
9
The
Netherlands
Belgium
19.8
6
4
12.0
3
2
Austria
9.8
3
2
Greece
4.0
3
2
92
63
Figure 2: Greece’s Debt Repayment Schedule
Six countries (Belgium, France, Germany, Italy, Netherlands and Spain) own Greek debt amount to
297.9 euro, or 90 % of the total debt of 331.4 euros.
What would be a possible classification into our 3 tranches? The amount owed to ESM is 141.9
which as % of GDP is 80%. We can treat the debt held by the ECM as secure. Table 4 summarizes
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some key information as well as how we would suggest that the Greek debt be classified in our three
tranche classification. The top half of the Table shows show the debt is currently distributed among
lenders such as the IMF and the ESM. The second half of the table shows how we propose to classify
the Greek debt, into our 3 tranches.
Table 4: GREECE’S DEBT AND THE NEW PROPOSED CLASSIFICATION
GREECE
Bilateral debt
EFSF/ESM
Securities Market
Program (SMP)
Intra-Euro system
liabilities
Total debt
Emergency
liquidity
assistance
EURO (in EURO (in
billions)
billions)
52.9
141.9
27.7
Comments
79%
Banks/private/ins
331.4
185%
80.0
ECB
GUARANTEES
107.4
Tranche 2
35.8
Tranche 3
188.2
Counter party
IMF/Government
EFSF/ESM
ECB
110.0
PROPOSED
DEBT
STRUCTURE
Tranche 1
TOTAL DEBT
Debt/GDP
60% Yes;
Maastricht
Treaty bonds
20% Yes;
infrastructure
bonds
NO;
Mezzanine
bonds
RECOURSE
ESM Members
331.4
Notice that Tranche 1 would conform to the letter and spirit of the Maastricht Treaty, although even
German debt now exceeds the Maastricht ultimate goal of being not more that 60% of GDP. We are
assuming that about 36 bn euro bonds are secured by the underlying infrastructure, so that in case of a
default, the bondholders can acquire these assets. The remaining debt of 188.2 euros would carry no
guarantee; it would be “mezzanine” debt and the market would determine the yields on this debt. There
is a danger that some or all of it could end up in the hands of vulture funds, but the ECB can avoid that
as argued below.
18
19
According to the IMF (July 14, 2015), Greek debt is expected to peak at close to 200 percent of
GDP in the next two years, provided that there is an early agreement on a program. Greece’s debt can
now only be made sustainable through debt relief measures that go far beyond what Europe has been
willing to consider so far. Mr Varofakis, the out-going Greek finance minister, has called the current
European Monetary Union’s refusal to grant debt relief an “extend-and-pretend” policy. He may be
right, as even the IMF has stated that the current Greek debt is unsustainable and there must be a
second haircut, as in 2012, when private bondholders of Greek debt took a 50% haircut. We saw that
in the event of the default of the EFSF/ESM loans, that debt would be “split up” among the ESM
members according to their paid-up capital share. Thus one possibility is to split up the remaining
Tranche 3 debt of 188.2 bn in proportion to the paid-up capital of the ESM. Thus Germany would
assume 27 percent of the total 188.2 bn and cover it with a German 30 year bond. France would do the
same with 20 percent of 188.2 bn, and issue a French long bond. And so on.
If the ECB does not take action and start to buy up this debt, then this debt will have a low
rating from the credit rating agencies. Its market value and yields would depend on supply and demand,
in turn affected by the ratings. But before some or all of it is acquired by vulture funds, Greece could
repudiate this debt as “odious debt.” But there is a simpler course that we outline below as a third
alternative; it requires action by the ECB through its policy of quantitative easing.
Under QE, the ECB must buy the debts of the 3 highly indebted countries: Ireland, Greece and
Portugal, to get the yields down. The ECB will be buying 60 bn worth of bonds every month. While
this program is expected to last until Sept 2016, the OMT program has no size or time limit. Note that
these became toxic assets due to the financial downturn of 2008-9. The ECB purchases would be a one
time purchase only, to get the 3 countries back on the steady state equilibrium path. These actions
would mirror what the US Fed when it took over Fannie-May and Freddy-Mac.
For Greece, ECB would steadily time phase the buying of the Tranche 3 debt of 188.2. For this
exercise, we can assume that Greek debt is bought first, in which case in about 3 months the Tranche 3
debt can be taken over by the ECB. In practice, the ECB will prioritize the purchases of the debts of the
3 countries, based on which has higher yields and needs to be mopped up first.
19
20
As of 18 June 2012, the ECB in total had spent €212.1bn (equal to 2.2% of the Eurozone GDP)
for bond purchases covering outright debt, as part of its Securities Markets Programme (SMP) running
since May 2010. On 6 September 2012, the ECB announced a new plan for buying bonds from
Eurozone countries. The duration of the previous SMP was temporary, while the Outright Monetary
Transactions (OMT) program has no ex-ante time or size limit. On 4 September 2014, the Bank went
further by announcing it would buy bonds and other debt instruments primarily from banks in a bid to
boost the availability of credit for businesses.
The Emergency Lending Assistance (ELA) program was designed for financial institutions in a
liquidity crisis, such as the Greek banks in the course of the 2015 Greek financial crisis, when the
banks experienced massive deposit flight. On 9 March 2015 the ECB started its quantitative easing
program, which was designed to ease sovereign stress in its member states. Purchases are €60bn per
month. The program is expected to last until at least September 2016.[See TABLE 4]
THE capital of the ECB comes from the 19 national central banks and on Jan 1, 2015 was euro
10.8 trillion. The paid up capital is 7.6 trillion, which is 70% of the capital. The ECB could buy the
Tranche 3 debt in a matter of three months, or it can spread it out over a few more months. As soon as
it starts buying Greek debt, the yields on Greek debt would fall. Any of the three routes suggested
above would bring Greek debt into “steady state” equilibrium.
CONCLUSION
Sovereign debt difficulties when there is a flexible exchange rate are in principle easier to deal with.
Thus Argentina will eventually be able to deal with that portion of debt not in foreign currencies.
However, in this paper we are concerned with sovereign debt when there is a fixed exchange rate, and
devaluation or depreciation is not a possible route. This is the case for many states in the USA (e.g.
Puerto Rico, or the state of Illinois), Ontario (in Canada), or Greece in the EMU. We propose a onetime transition to equilibrium to some steady state equilibrium. Once in equilibrium, all sovereign
bonds would fall into three categories of Tranche 1, 2 and 3.
20
21
The first tranche of sub-sovereign debt, up to some limit, would be secured by some
supranational entity; this would be clear from the bond prospectus. The second tranche would be debt
for collateralized infrastructure assets, so that in the case of a default, creditors would acquire the
underlying assets. The third tranche would be all unsecured sovereign debt when the country exceeds
pre-set guarantee percentage, for example as when the debt/GDP ratio target in the Maastricht Treaty is
exceeded. Thus in a steady state equilibrium, all sovereign debt would conform to these categories, and
risks would be priced by the market. However when a country’s debt is out of equilibrium, a transition
path back to steady state equilibrium is required. We indicate one possible transition for Greece. We
show that when the financial institutional structure is incomplete or inadequate for debt defaults (as is
the case for the EU), reliance on the market is not only possible but also preferable. The only
precondition for a market-based solution is that an informational asymmetry be eliminated. This
asymmetry is a missing market with a profit making opportunity, which can be filled by debt-rating
agencies.
21
22
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