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An Orderly Market-Based Approach to the Restructuring of Eurozone Sovereign Debts Obviates the Need for Statutory Approaches
By Nouriel Roubini
- EXECUTIVE SUMMARY
Europe’s financial crisis has intensified with Ireland on the verge of losing market access and consequently in danger of defaulting on its debts in the next few months. It is likely that the short-term response of the EU will be to bailout Ireland to prevent contagion to the rest of the eurozone via a combination of the European Financial Stability Fund (EFSF) and IMF loans. However, this approach would merely act to “kick the can down the road,” and would not provide a permanent solution to Ireland’s sovereign distress problems, with the risk of moral hazard being a further disadvantage. For the long term, the EU is now actively considering a European Sovereign Debt Restructuring Mechanism (SDRM) or Credit Resolution Mechanism (CRM) to restructure public debt through a statutory mechanism in an orderly manner. Such a mechanism would establish “bail-in” procedures (haircuts or other losses imposed on private creditors) alongside permanent bailout funding facilities. However, in the meantime, this paper argues that existing market instruments—i.e. exchange offers—are sufficient to achieve orderly but coercive restructurings of sovereign debt, with such instruments having previously been successfully used to restructure the debt of many emerging market economies. Therefore, the establishment of new legal technology, a CRM or SDRM, for sovereign debt restructurings is not necessary; rather, a contractual or market-based approach would be sufficient. We show that many of the advantages of a CRM/SDRM, such as the avoidance of “rush to the exits,” “rush to the courthouse,” “free rider/holdout,” “DIP financing” and “systemic risk” externalities or market failures, can be achieved without the need for changes in EU treaties to be approved and implemented—inevitably a multi-year process.
Ireland is now on the verge of following Greece into the Land of Lost Market Access. At the same time, sovereign spreads continue to widen for the rest of the PIIGS (especially Portugal but also for Spain and Italy). If, as appears likely, Ireland ends up losing market access, the short term response of the EU will be feature a rerun of last spring’s Greek solution: kicking the can down the road with a bailout package (a combination of EFSF support and IMF loans) to prevent systemic contagion spreading to the rest of the eurozone and to global financial markets. The same prescription awaits should Portugal lose market access in the next few months.
The EU implicit view holds that, even if “bail-ins” of private investors—via coercive restructurings of public debt—eventually become unavoidable, better to postpone them a couple of years and hope that the time thus gained will ring-fence Spain. Unlike Greece, Ireland and Portugal, whose loss of market access can be supported with official financing (EFSF, EU and IMF) for the next three years, Spain is too big to fail but also too big to save or to bail out. Thus, kicking the can down the road for the three little PIIGS now facing greater short term risk of distress is the EU’s preferred strategy. The hope, of course, is that this buys time for an orderly restructuring of the debt of these countries—a restructuring which would be less disorderly and with less systemic effects if Spain can in the meanwhile implement fiscal and structural policy.
At the same time it has finally dawned on EU policy makers that: a) socializing private losses and piling them onto the balance sheets of EZ governments will eventually break their sovereign backs, deepening their insolvency; b) when lack of fiscal discipline—Greece—leads to an unsustainable deficit and debt burden even necessary fiscal adjustment will not be sufficient to avoid the eventual need for debt restructuring. Brussels also has grasped that massive, official bailouts in the Greek mold increases moral hazard and works only in cases of distressed, illiquid but otherwise solvent sovereigns. That, in our judgment, is not the case. The weaker EZ’s peripheral economies already are near insolvent and thus such unconditional bailouts, without any bail-in of creditors, merely postpones the day of reckoning: an eventual debt restructuring down the line which will cause far more damage than grasping the nettle soon.
Faced with this reality—something RGE warned of as early as the spring of 2010, the option of private sector investors’ bail-ins—rather than only bailouts—is now being actively considered. Indeed, the recent blowout of Irish and other PIIGS sovereign spreads is directly related to the tentative agreement (reached first by France and Germany and later endorsed by the broader EU) for creation of a Crisis Resolution Mechanism or CRM to tackle restructurings of sovereign debts starting in 2013, when the current EFSF expires. The CRM seeks to ensure orderly sovereign restructurings while providing a more permanent source of official funding to distressed sovereigns. Thus, the EU is now seriously considering creating a CRM that provides both bailouts–a permanent EFSF or European Monetary Fund--for illiquid but solvent sovereigns while at the same time designing a bail-in mechanism that imposes haircuts or other NPV losses on the private sector creditors of a distressed, potentially insolvent EU sovereign should that become desirable.
Moreover, a number of academics and European think tanks (such as a group of economists at the Bruegel Institute and Jeromin Zettelmeyer of the EBRD) have made similar proposals for a European CRM or Sovereign Debt Restructuring Mechanism (SDRM). The same debate occurred in 2001-2002 when Anne Krueger and the IMF proposed an SDRM to ensure an orderly restructuring of emerging markets’ sovereigns found to be insolvent. At that time, the IMF and others made an argument in favor of a statutory approach to sovereign debt restructurings (effectively creating an international bankruptcy mechanism for sovereigns or SDRM) while others (see for example Chapter 7 of Nouriel Roubini and Brad Setser’s 2004 book, “Bailouts or Bail-Ins? Responding to Financial Crises in Emerging Economies”) argued that a contractual or market-based approach (based on exchange offers perhaps augmented with collective action clauses) was sufficient to achieve orderly sovereign debt restructurings.
This paper will show that, as in the case of the IMF’s SDRM, a European SDRM is unnecessary for an orderly restructuring of European public debts. The experience of emerging market economies shows that such orderly restructuring can easily occur—without a new legal sovereign bankruptcy mechanism—through the tool of exchange offers that were successfully implemented before a formal default (in the cases of Pakistan, Ukraine, Uruguay, Dominican Republic and a few other economies) or after formal default (in the cases of Argentina, Russia and Ecuador).
A new legal protocol for sovereign debt restructurings is not necessary because experience has suggested that the potential market failures and externalities which allegedly prevent orderly restructurings can be resolved through a variety of existing market mechanisms. Let’s start by looking at the arguments on behalf of SDRM, each of which, as you will see, fails to hold water.
1. The ‘Rush to the Exits’ Externality
The first argument made for the need for an SDRM is the “rush to the exit” externality: Investors whose claims are very short term or close to maturity would roll off their claims, triggering a disorderly default and imposing greater losses on the other creditors; thus a formal SDRM locks in such investors’ claims and prevents the rush to the exits. The SDRM would allow—as in a Chapter 11 bankruptcy in the U.S.—an orderly debt standstill of all claims thus preventing some creditors, lucky enough to have claims that are very short-term or near maturity, to be paid in full while creditors with longer maturity claims suffer greater losses.
The reality is that you don’t need a legal mechanism to stop the rush to the exits externality: A country can unilaterally declare a debt standstill, temporarily suspending the roll-off by freezing payment on all claims, short-term or long-term, while it is preparing an exchange offer for a formal restructuring of its debts. Some may ask, ‘But doesn’t this amount to a default?’ No, because the country in question can avoid the formal default by allowing the roll-off of short term claims, which anyway usually would be excluded from a debt restructuring as such claims are considered as being effectively senior to other claims. The country would then proceed to an exchange offer before a formal default is declared. So, with the caveat that short-term claimants are not bailed in, a pre-emptive exchange offer instead of a formal default can lock in most creditors and effectively lead to a debt standstill, thereby avoiding a rush to the exits without triggering a formal default.
2. The ’Rush to the Courthouse’ Externality
The second argument for an SDRM is the “rush to the courthouse” externality: If default or debt standstill does occur before an exchange offer has been implemented, creditors may try to attach the assets of the sovereign in a disorderly way via a “creditor grab race.” The alleged benefit of a formal SDRM is avoidance of this scenario as the bankruptcy court can impose stay on litigation: All claims fall into the bankruptcy mechanism without the risk that some creditors swiftly attach the debtor assets before others and gain an advantage during the payoff phase. Yet the case of Argentina’s default in 2002 proves this problem is a red herring. That instance demonstrated that sovereign immunity is effectively so strong that very few of the assets of a sovereign can be attached in any court. Also, unlike the case of emerging market debt that is usually issued in a foreign jurisdiction (either London or New York), most of the sovereign debt of the eurozone members is issued at home (for example 95% of the public debt of Greece has been issued in Greece). This further sharply reduces any risk that foreign or domestic creditors can attach the assets of the sovereign. If it is hard to attach assets for debt issued in a foreign jurisdiction it becomes near impossible to do that for debt issued in a domestic jurisdiction. And, of course, the rush to the courthouse is altogether prevented if the country does a pre-emptive pre-default exchange offer that avoids altogether a formal debt standstill.
Moreover, since there is no cross default between debt issued at home and debt issued abroad, Greece or other distressed eurozone sovereigns could minimize the litigation risk by making an exchange offer only for the domestic debt and exempting the foreign-issued debt, the latter being so small as to be nearly insignificant—for debt servicing burden purposes. Restructuring the 95% of the debt that is domestic would provide massive debt relief without ending up in the potential legal quagmire that would result from restructuring foreign issued debts. It is true that domestic debt is usually subject, as in the Greek case, to the option of individual creditor acceleration rather than the more standard majority approved acceleration clauses. But this risk—as well as other minor legal risks—can be easily resolved by introducing perfectly legal and enforceable legislation that changes the acceleration clauses for the domestically issued debt to impose a qualified majority approved acceleration.
3. The ’Free Rider’ or Holdout Externality
The third argument for a formal SDRM is the “free rider” externality or collective action problem in debt restructuring. Unless the debt already includes collective action clauses (CACs), which can cram down on holdouts any restructuring agreement reached by a qualified majority of creditors, there is a severe risk of free riding by holdouts. Far better, then, for each investor to reject the offer, let others accept it and then be paid in full on its holdout claims. But if every creditor behaves this way the exchange offer will fail as very few will accept it in the first place, making an orderly restructuring that benefits both creditors and the debtor impossible. Moreover, unanimity clauses imply that even one single holdout can prevent an orderly debt restructuring; so even a restructuring accepted by 99% of creditors could be scuttled by the refusal of a minority of creditors to accept it. The alleged advantage of a formal SDRM in this case is that the bankruptcy court or mechanism could cram down on holdouts the terms of a debt restructuring accepted by a qualified majority of creditors.
However, the market mechanism to bypass the free rider problem—i.e., that changing the financial terms of any sovereign debt requires the unanimity of all creditors—is an exchange offer: You don’t change the financial terms of the old debt that requires unanimity. Rather, the old debt is exchanged with new debt that has new financial terms regarding maturity, interest rate and face value. Thus, the unanimity problem is bypassed altogether because new debt with new terms can be accepted a significant majority of creditors and not be blocked by a minority of holdouts. The residual risk of holdouts remains in the case of exchange offers: Some creditors may not accept the offer and thus free ride by keeping the old debt and be paid in full and in time on it. But in all of the emerging markets restructurings via exchange offers the holdouts turned out to be only a very small fraction of the creditors; in most cases over 95% of creditors accepted the offer.
Why is that the case? Why we did not see many more holdouts in EM restructuring cases given the free riding incentive of holding out and the lack of majority cram-down clauses? There are several reasons: first, as long as the exchange offer is done at a market value for the new debt that is equal to the current price of the debt (a price that always trades at a discount relative to par since spreads have blown out for distressed sovereigns at risk of restructuring) most creditors will accept the offer as it implies no further mark-to-market loss for such investors. Such investors instead switch to new claims with the same market value that are at lower risk of default rather than hold on old claims that be not be serviced after the exchange offer.
Second, if the sovereign can credibly commit not to pay in full the holdouts or even default on the old debt after an exchange offer any potential holdout risks to be stuck for a long time with an illiquid instrument that doesn’t pay either interest or principal. This is, for example, what happened to the retail investors in Argentina who did not accept the 2005 exchange offer; they waited for another five years with claims that were not serviced and eventually accepted an offer with worse terms than the first one. Thus, in practice the holdout problem, even in the absence of majority enforcement clauses, has turned out to be a non-issue.
Not incidentally, CACs, such as majority enforcement clauses, can be included, as they have been in EM restructuring cases, in the new debt of the exchange offer to make future bail-ins—if proven necessary—even more orderly. Indeed, in the cases of Uruguay and other EM sovereigns, CACs could be introduced into the new debt so as to make restructurings more orderly in case the initial haircut proves to be insufficient and, in a few years, a further restructuring becomes necessary. Introducing such CACs into new debt has passed relatively unnoticed by investors as sovereign spreads in emerging markets have not increased following the introduction of CACs. By allowing future orderly restructuring, it allows to limit the amount of NPV loss imposed on investors in the first restructuring in situations where the needed amount of eventual NPV debt relief is uncertain.
Moreover, in the Greek case, as well as that of other eurozone sovereigns, a large fraction of the debt is held by a relatively small number of financial institutions in Europe; thus the holdout risk existing in cases of a broader ownership of such debt are more limited in the Greek and PIIGS cases given the greater concentration in the ownership of the debt. But note that even in cases–like those of emerging markets where the debt was held by a large number of creditors—in some cases hundreds of thousands or millions of them, the holdout problem turned out to be a non-issue.
3a. The CDS Bugaboo
A new variant of the free rider externality argument is that the existence of sovereign CDS—non-existent a decade ago—could make a market-oriented debt restructuring more difficult or even impossible. According to this argument, holders of CDS protection could follow a “restructuring sabotage strategy” and prevent an orderly restructuring. But first note that such sabotage strategy would be a problem even if one were to take a statutory approach to sovereign debt restructuring: Indeed, if this was an issue how could a CRM or SDRM prevent creditors of a sovereign who do have CDS protection from following such alleged “sabotage” strategy? But the most important point is that the argument that CDS make restructurings more difficult, whether in a statutory approach or in an exchange offer approach, is quite weak.
First, consider that any holder of CDS protection would not be a creditor of a distressed sovereign unless he/she has an actual long position in the underlying bonds; holders of CDS protection don’t vote in a debt restructuring process (i.e., an exchange offer) if their CDS protection is naked without any underlying actual exposure to the bond.
Second, even if a holder of CDS protection were to be a bondholder his/her voting power would be limited to his/her actual exposure to the bond. So, suppose the bond includes a majority cram-down clause (say two third or three quarters majority rule). Then, unless the bondholder with CDS protection controls a quarter or a third of all the bonded debt of the sovereign he/she would not be able to sabotage a restructuring beneficial to other creditors and to the sovereign.
Third, since most likely an exchange offer under threat of default is considered—as it is by rating agencies that considered them as coercive thus triggering a selective default rating–as a credit event that triggers the CDS an holder of CDS protection would be paid regardless of whether he/she has underlying exposure to the bonds and regardless of whether he/she tries to sabotage the debt restructuring. In effect, the holder of CDS protection has no incentive to sabotage a restructuring because such a restructuring is by itself a credit event that triggers the CDS regardless of whether the restructuring is successful or not.
Fourth, the only case where a CDS holder would be willing and able to sabotage a debt restructuring would be if the exchange offer is somehow not considered a credit event (highly unlikely as these offers are done coercively under the threat of default and are considered as credit events by rating agencies), and if said creditor has such a large percentage exposure to the bonded debt of a sovereign—one-quarter or one-third—that by casting his or her vote against a qualified majority rule, he could scuttle an orderly restructuring and trigger an actual default by the sovereign. So, while the existence of CDS may at the margin complicate any sovereign debt restructuring—even one that occurs in a formal bankruptcy court, in practice this is not a relevant issue or would be as much of an issue in a statutory approach as it would be in a contractual approach.
4. The ‘Debtor-in-Possession Financing’ Externality
The fourth argument for an SDRM is the need for Debtor-in-Possession (DIP) financing externality: Even a defaulting debtor needs new financing—that has to have seniority over older claims—to make the economic restructuring that goes along the debt restructuring viable. A formal bankruptcy mechanism includes DIP financing as the court has the authority to make new DIP financing senior to previous claims. Again, you don’t need a formal SDRM to get such DIP financing: IMF rules allow “lending into arrears—i.e., DIP financing—by the IMF for sovereigns in default but are negotiating in good faith with their creditors toward a debt restructuring. Similarly, the rules of the EFSF could be extended to allow such lending into arrears financing (i.e., DIP financing) for eurozone sovereigns in default or temporarily in arrears on their sovereign obligations.
Indeed, any proposal for a CRM or European Monetary Fund includes the idea of lending facility—more permanent than the EFSF—to provide official financing to a distressed sovereign either before a debt restructuring or during and after one. One should note that EFSF lending doesn’t have the same seniority as IMF lending that is de facto—but not de jure—senior to all other private claims. Rather, the IMF has the same seniority as other bilateral government-to-government debt (i.e., Paris Club debt). Still, the Paris Club claims tend to be senior relative to private claims, and since EFSF lending would be formally a form of DIP financing that occurs after previous debt has been in distress, formal rules to ensure that EFSF funding is senior relative to private sector claims—if less senior than IMF claims—can be designed without a formal SDRM. And the EFSF lending could become formally as senior as IMF lending if, in the future, the EFSF were to be turned into a multilateral lending facility such as a European Monetary Fund or a European CRM. Finally, the whole issue of lending into arrears is bypassed if a pre-emptive exchange offer avoids a formal default: then official financing is viable (via the EFSF or the IMF lending) even without lending into arrears as the sovereign has not technically defaulted or imposed a debt standstill.
5. The ‘Systemic Risk’ Externality
Finally, there is the argument that a legal mechanism to reduce the risk of systemic contagion to other countries would be necessary to sidestep this potential externality of debt restructurings. But pre-emptive exchange offers can also reduce the risk of systemic financial contagion. First of all, when there is a pre-emptive exchange offer formal default is avoided and thus the risk of contagion more limited. Second, losses to private financial institutions that hold a lot of the sovereign debt can be postponed—as these institutions keep most of their holding of sovereign debt in the banking book not trading book—via exchange offers with par-bonds (as in the case of the Brady par bonds) where the face value of the debt is not reduced.
Indeed, as the case of Pakistan, Ukraine, Uruguay and Dominican Republic show, where formal default was avoided via a pre-emptive exchange offer that avoided reducing the face value of the debt–any amount of net present value (NPV) effective debt reduction and debt relief for a sovereign debtor can be achieved for a sovereign via a significant maturity extension (the new debt has much longer maturity than the old debt) and by capping the interest rate on the new debt well below current distressed market yields and spread even if a face value reduction is not formally included in the new debt. Maturity extension and capping of the interest rate below market rates is equivalent to face value reduction even if such formal face value reduction is not included. Indeed the Brady par bonds and discount bonds had the same value—with one having no face value reduction—and appealed to different creditors: those who did not mark to market (mostly banks) and those who did (capital market investors).
Of course, since an exchange offer implies NPV losses for investors they will be willing to accept the new debt only under the threat of default. This is the reason why exchange offers are usually considered by rating agencies as episodes of selective default: the implicit–if not explicit–threat of default that induces creditors to accept new debt with worse financial terms, maturity, interest rate and possibly face value. Thus, while they are more market friendly and involve smaller NPV losses for investors than outright defaults followed by exchange offers, such pre-emptive exchange offer are still coercive because they work under the threat of default.
In practice, exchange offers—rather than a formal court mechanism—have been used in all cases of emerging market economies whose sovereigns were distressed and in need for debt restructuring/reduction/relief. In cases in which the sovereign was obviously insolvent—Russia, Ecuador, Argentina—the exchange offer occurred after formal default–debt standstill—and the new debt included formal face value reduction as the required haircut imposed on creditors was significant. In less severe cases of sovereign distress where the sovereign was near insolvent but also illiquid, had lost market access and was facing large lumpy debt servicing payments that could not be serviced given the loss of market access the orderly debt restructuring also occurred via exchange offers but those offers were pre-emptive and formally avoided a debt standstill/default (Pakistan, Ukraine, Uruguay and Dominican Republic); moreover, those exchange offers did not include a reduction of the face value of the debt as the amount of necessary NPV debt reduction was smaller and could be achieved via maturity extension and capping the interest rate on the new debt rather than face value reduction.
6. Other Alleged 'Red Herring' Externalities or Market Failures
In the debate on statutory versus contractual or market-based approaches to sovereign debt restructuring, other alleged externalities or market failures have been cited in order to advocate the superiority of a statutory approach. All of them have effectively turned out to be red herrings as market-based approaches can practically deal with any one of such alleged market failures.
For example, it has been argued both that without an SDRM a sovereign is likely to postpone a necessary debt restructuring or strategically/opportunistic to default even when such debt restructuring is not necessary. Leave aside the fact that the two arguments are really just one argument (each the opposite of the other, i.e., that without SDRM a debt restructuring is more likely and less likely). In reality, a bankruptcy court cannot force a debtor, especially a sovereign one, to default. That decision always rests with the sovereign debtor when it runs out of money and/or is unable/unwilling to service its debt.
As in the cases of EM economies, if the official sector (IMF for the EM, the EU for its member states) comes to the conclusion that a distressed sovereign who is unwilling to consider a debt restructuring needs to be coerced—or more politely nudged in that direction, that goal can be instantaneously achieve by pulling the plug of official financing on a sovereign that has already lost private market access or is on the verge of losing market access. Indeed, in EM cases, the IMF/G7 nudged distressed sovereigns into a debt restructuring by withholding official financing or making it conditional on starting a debt restructuring process. Similarly the IMF or the EU can trigger a debt restructuring of a recalcitrant EU member state that refuses to consider such restructuring by not providing official financing (IMF loans or EFSF financial support).
At the same time, the existence of an SDRM doesn’t make a default more likely or a strategic/opportunistic default more likely as sovereign debtors have not been in practice trigger-happy and have tended to postpone default for as long as they can—as long as they can finance themselves through private or official financing. Moreover, the wide literature on sovereign debt shows that the cost/benefit calculus of a debt restructuring is independent of a well designed SDRM as such a statutory mechanism doesn’t necessarily make a restructuring cheaper or easier for a debtor when market based approaches are good alternatives to a statutory approach. Similarly, a statutory approach doesn’t not resolve the fundamental problem of determining the size of the debt haircut in a debt restructuring. This is “the” key issue in any debt restructuring as it represents the financial losses that are borne by creditors. The haircut issue is resolved in a market-based approach with the debtor having to make an offer that will be accepted by a large majority of bondholders, i.e., an offer that maximizes the fraction of creditors who accept it and minimizes the fraction of potential holdouts. And even in proposed statutory approaches, the bankruptcy court would not have the power to cram-down on creditors any arbitrary haircut; the size of the haircut–as in a market based approach–would have to be approved by a qualified majority of creditors. The only additional partial benefit of a statutory approach is that the court or mechanism has majority cram-down powers; but a contractual/market-based approach achieve the same results via CACs (majority enforcement clauses) or via exchange offers that by-pass any unanimity clause in the old debts and effectively minimize holdout externalities. Thus, a statutory approach is not superior—it is rather inferior or at best equal—to a market based approach in resolving the key issue in any debt restructuring, i.e., the haircut or losses that will be imposed on creditors.
In summary, a European SDRM is not necessary to achieve an orderly restructuring of public debts of eurozone members. Such restructuring can be achieved in an orderly manner any time via the traditional tool of exchange offers that have been successfully been used for emerging market sovereigns in distress. Thus, the current debate on a European SDRM is a total red herring: The reason why the EU has so far decided to provide financing to member states in distress is not the lack of a legal mechanism for an orderly restructuring; rather, it reflects concern about systemic contagion. But an orderly restructuring via exchange offers can significantly reduce such a risk while providing significant debt servicing relief to sovereign that are financially distressed via an orderly—if coercive—debt restructuring.
This is not to argue that a European SDRM would serve no purpose if it could be somehow agreed upon and implemented rapidly. For example, CACs in sovereign debts of EZ members would be useful to have. It is rather that the features of any formal SDRM can be replicated—in order to achieve orderly sovereign debt restructurings—through existing market mechanisms that don’t take years and ratified changes in EU treaties—to put in place. The current tragedy is that the European debate on a crisis resolution mechanism or SDRM has had perverse effects: It has not made sovereign restructurings more likely or more orderly or more likely to occur sooner.
Instead, the talk about a European SDRM has been the trigger of the recent blow-out of Irish spreads and created greater turmoil than order. Additionally, the confusing and contradictory remarks of EU officials and national leaders on when the restructuring mechanism will take effect and to which debts it will apply (new or old ones) has created greater uncertainty among investors. The reality is that, regardless of what the EU says or doesn’t say, the probability of a coercive restructuring of the Greek or Irish debt is totally independent of whether a European SDRM will be created in 2013 or later and whether its terms would apply to new or old debt. The EU has zero effective power in deciding—via a new legal mechanism—whether Greece or any other EZ sovereign will restructure its debt and when.
Indeed, if Greece does not regain market access it will be forced to restructure its debts when the IMF/EU bailout program expires even if, as possible, the IMF or the EU were to decide to maintain its exposure to Greece upon expiration of that official support. In effect, if Greece doesn’t regain its market access, its need to finance its new yearly deficits and to rollover private claims coming to maturity will force a debt restructuring. To prevent this, IMF/EU would have to not only extend their existing program but, on top of that, significantly increase its lending/financial commitments beyond the current €110 billion lending envelope since Greece will have large financing needs beyond 2012 given its ongoing fiscal deficit and need to rollover private claims coming to maturity. This is why the recent statement by some European finance ministers asserting that the proposed debt restructuring mechanism will apply only to debts issued only after 2013—a statement which backpedaled away from previous pronouncements in order to calm spooked bond markets—is totally meaningless. Unless the EU and/or the IMF are willing to commit to an open-ended full servicing of the entire financing needs of distressed EU member states, including current debts coming to maturity and new financing related to the new flow deficits, the idea that any restructuring will apply only to debts issued only after 2013 lacks credibility and, worse, is deceptive.
Moreover, the recent statement of a sub-set of EU finance ministers that haircuts will be imposed on new debts issued after 2013 not the old one is actually counter-productive and ensures that PIIGS in distress will lose market access rather than regain it over time: Why would any private creditor of a PIIGS want to purchase the newly issued debt of such a sovereign when such debt—rather than the old one—would be restructured? The whole logic of DIP financing is that new debts get seniority relative to old debts—that are already locked in—to ensure that new financing arrives to a sovereign under distress. The weird EU view that new debts—rather than old ones—would be subject to debt restructuring turns the basic principle of DIP financing on its head and ensures that market access will be lost even to distressed sovereigns that still have such access.
Thus, the existence of a European SDRM is totally irrelevant to the probability and timing of a debt restructuring in Greece, Ireland or other distressed EZ sovereigns. As argued in this paper, orderly coercive restructurings can occur at any time—even today—without any new legal mechanism for sovereign debt restructuring. So far, the talk or contradictory babble about a European CRM or SDRM has only obscured the basic issues rather than resolving them. In the best of all scenarios, it would take at least until 2013 to design and create a European CRM or SDRM; most likely, it will take much longer as any statutory approach to sovereign debt restructuring implies changes in EU treaties that, as experience suggests, take much longer to be approved by the member states. So while the rhetoric of the EU has been recently to talk hard about the need for bail-in of private creditors, the effective result of the current debate about a European CRM would be to postpone for too long—compared to the restructuring needs of the member states—a debt restructuring if one were to take a statutory approach to sovereign debt restructurings.
Similarly, recent semi-academic proposals for an European CRM (such as that of the Bruegel Institute that includes among its co-authors Anne Krueger, the original proponent of the IMF’s SDRM) rehash the old arguments in favor of a statutory approach to sovereign debt restructuring for Europe while failing even to notice or recognize that a score of EM economies restructured in a orderly way their sovereign debts before default via pre-emptive exchange offers (Pakistan, Ukraine, Uruguay and the Dominican Republic), or that the same approach was used for the successful restructuring of the debt of other sovereigns who defaulted on their public debt (Russia, Ecuador, Argentina). This failure, in this high profile proposal in favor of a new EU statutory mechanism (ERCM), to even acknowledge the successful use of exchange offers in all of the EM sovereign debt restructurings that took place over the course of more than a decade is puzzling at best and deceptive at worst.
The similar failure has afflicted EU policy officials. Today, they correctly worry about avoiding systematic sovereign bailouts and are belatedly considering ideas for a bail-in of private creditors. Yet, in the days since the Greek crisis first flared, they failed to grasp that a statutory approach to sovereign debt restructuring that might be ready by 2013 is both unnecessary and ill-suited to the crisis upon them. A wiser, more cautious approach would have emphasized the usefulness and applicability of market-friendly contractual or market-based approaches rather than more coercive statutory approaches. This path could have prevented the recent sovereign spread turmoil that has almost pushed an already severely distressed Ireland close to the verge of the default cliff. And the latest EU back-pedaling, after significant damage to investors’ confidence had already been inflicted, further muddled the issues, undermining the EU’s credibility with the nonsensical and perverse idea that a new restructuring mechanism would apply only to new debts issued after 2013, a counter-productive idea that ensures that distress sovereigns will lose market access.
The whole debate on statutory versus contractual approaches to sovereign debt restructurings was settled in practice almost a decade ago when, in spite of the conceptual arguments for a statutory approach, orderly debt restructurings of sovereign public debt was achieved without a formal bankruptcy or statutory regimes by using market approaches. Indeed, that experience showed that even the whole debate about collective action clauses (CACs) was irrelevant as the first round of successful sovereign exchange offers all occurred even in the absence of CACs (especially majority enforcement/cram-down clauses) that were alleged to be necessary to avoid free riding or holdout externalities. Such CACs did not exist in the old debts that were exchanged and were introduced only in the new restructured debts. So, even a basic majority enforcement/cram-down clause proved not to be necessary to achieve orderly sovereign debt restructurings.
In conclusion, orderly but coercive restructurings of sovereign debt–including that of EU or eurozone members–can be achieved with existing market instruments that have been successfully applied for over a decade to the restructuring of the bonded debt of many sovereigns in emerging market economies. Orderly and early debt restructuring can also significantly reduce the risk of systemic contagion to other eurozone members and to the region’s financial institutions. The constraints for an orderly debt restructurings are not legal–the lack of a formal crisis resolution mechanism; they are rather political: i.e., when will the EU agree that some of its member states are not just illiquid but near insolvent and thus in need of an orderly market based restructuring of their public debts that would provide debt relief while limiting the risk of a systemic contagion to the rest of the eurozone.
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at NYU’s Stern School of Business. He is co-author with Brad Setser of the book, “Bailouts or Bail-ins? Responding to Financial Crises in Emerging Economies” where the arguments for and against sovereign debt restructuring mechanisms are discussed in great detail in Chapter 8. A short excerpt of this clients-only piece was published in the Financial Times.