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Is restructuring through the back door possible?

What’s at stake With the on-going discussion surrounding the qualitative and quantitative changes to the EFSF, talk of a peripheral debt restructuring is becoming harder to avoid for European leaders. The attention has focused on ways the EFSF could be used to either buy back or exchange existing debt of peripheral countries. While the idea has been endorsed […]

By: Date: February 11, 2011 Topic: Macroeconomic policy

What’s at stake

With the on-going discussion surrounding the qualitative and quantitative changes to the EFSF, talk of a peripheral debt restructuring is becoming harder to avoid for European leaders. The attention has focused on ways the EFSF could be used to either buy back or exchange existing debt of peripheral countries. While the idea has been endorsed publicly by a number of policymakers (J.C. Trichet, C. Lagarde) and a by a number of academics it seems to be stumble on a few important practical considerations as outlined by a new Bruegel report.

Klaus Regling, the chief of EFSF, has suggested voluntary debt forgiveness as a response to the widely regarded notion that, even with extra time, the debt-stricken eurozone economies will be unable to repay their debts in full. According to his proposal, Greece could give investors the option to sell their bond holdings at a premium to the current market price. The credit line for this transaction would come from the EFSF. The prerequisites for this approach are additional guarantees and full ability to mobilise €440 billion. However, the effectiveness might still be questionable since European banks (who hold a sizable proportion of troubled bonds) could be unwilling to materialize such losses; current accounting rules serve as a disincentive to voluntary forgiveness. Nonetheless, the support for this proposal is growing amidst both politicians (albeit privately) and economists.

Daniel Gros and Thomas Mayer proposes in a new paper a two-step, market-based approach to debt reduction. The European Financial Stability Facility (EFSF) would offer holders of debt of the countries with an EFSF programme (probably Greece, Ireland and Portugal = GIP) an exchange into EFSF paper at the market price prior to their entry into an EFSF-funded programme. The offer would be valid for 90 days. Banks would be forced in the context of the on-going stress tests to write down even their banking book and thus would have an incentive to accept the offer. Once the EFSF had acquired most of the GIP debt, it would assess debt sustainability country by country. If the market price discount at which it acquired the bonds is enough to ensure sustainability, the EFSF will write down the nominal value of its claims to this amount, provided the country agrees to additional adjustment efforts. 
If under a central scenario this discount is not enough to ensure sustainability, the EFSF might agree on a lower interest rate, but with GDP warrants to participate in the upside. A key condition for this approach to succeed in restoring access to private capital markets is that the EFSF claims are not made senior to the remaining claims and the new private bondholders. EFSF support must be comparable to an injection of equity into the country.

Paul Krugman
argues that market based debt buy backs are ineffective in achieving actual debt reduction to the debtor. They can be confidence enhancing but not debt reducing in any meaningful fashion. In a paper written to analyse a Rube Goldberg-type scheme for Latin debt reduction, Krugman shows that these schemes will benefit both debtor and creditor only when the debtor is on the wrong side of the "debt relief Laffer curve" – that is, where a reduction in nominal claims actually increases expected payment. This is, however, also the case in which unilateral debt forgiveness is in the interest of creditors in any case. The implication is that there is no magic in market-based debt reduction, as opposed to more straightforward approaches. Paolo Manasse gives a numerical illustration of Krugman’s points about the ineffectiveness of market-based restructurings, debt buy backs and swaps. The example shows that if the purpose of the restructuring is to reduce the burden of payments for the debtor and to have creditors sharing the losses, a unilateral partial default or a debt swap seem largely preferable to a buyback.

Ken Rogoff and Jeremy Bulow
argue in a 1988 paper that there are two reasons why buybacks are by themselves a boondoggle benefiting a country’s creditors. The first concerns the relation between “average” and “marginal” debt. A country using the market to retire part of its debt in a buyback pays a price equal to the average value of debt. However, the reduction in the value of the country’s obligations reflects the marginal value of debt, which is less than the average. The second disadvantage of sovereign buybacks, which does not apply to domestic debt repurchases, derives from the special nature of the “collateral” underpinning sovereign debt. The relation between a debtor’s reserves and its future repayments is much more tenuous for countries than for domestic borrowers. When a domestic borrower repurchases debt, it uses assets that otherwise could be seized in the event of default. Using assets that way reduces the gain to bondholders from a buyback and makes the transaction more attractive to the borrower. Because a sovereign’s repurchase does not imply the same reduction of lender’s collateral, the transaction tips heavily in favor of the lender, and the value of any remaining debt will rise.

The euro area debt crisis blog
points that if we assume that markets are efficient, a bond buyback would not significantly reduce the overall debt stock. If the EFSF lends enough to Greece that it can buy its way back to solvency, the markets will bake this into bond prices. Prices will soar and yields will fall, at which point the funding from the EFSF will no longer stretch far enough for Greece to repurchase the debt necessary to restore fiscal solvency. Rather than reduce overall debt levels, a bond buyback scheme will therefore only serve to depress bond yields and, in turn, do little to improve Greece’s fiscal situation.

Tyler Cowen
argues that the purchase might work if the Greek government can signal they don’t have inside information about their own ability or willingness to pay back the money.  That’s hard to do, but not impossible.  After all, companies do buy back their own shares and I don’t think tax arbitrage is the only motive.  For instance the company also may wish to shift the composition of its creditors and perhaps governments have the same motive.  Then the purchase can be a win-win. Another equilibrium is if the Greek government offers to buy back the bonds with some probability.  Sellers might then play a mixed strategy in response and maybe then we are getting somewhere, with some probability that is.  These games usually are complicated and if you don’t already get the intuition here don’t bother with it.

FT Alphaville
quotes Ralf Preusser from Bank of America on potential problems associated with Buy Backs: (i) debt reduction is achieved only for countries that have to pay the EFSF a high interest level, (ii) maturity extension would argue for buying short term debt which is more expensive, (iii) the exchange offer needs to be time bound (iv) to make a time bound offer, the EFSF needs to be prefunded, (v) the EU would end up being the sole creditor of the periphery bearing all the credit/restructuring risk.

Jeromin Zettelmeyer and Federico Sturzenegger
wrote in a 2006 IMF Research Paper a detailed account of previous “friendly” debt exchanges / buy backs and reached the conclusion that the losses to the creditors do not necessarily equate the debt reduction achieved by the debtor. The difference lies in the potentially important changes in the discount rate, i.e. the rate at which the debtor can borrow after its restructuring / buy back.

Joseph Cotterill
argues that the EFSF is turning into a provider of high quality collateral. He quotes the Finanzagentur chief arguing that there is “more power behind the EFSF than with regular sovereign debt” and argues that the benefit of using the EFSF to proceed with a debt exchange is that it explodes the idea that modern sovereign debtors can get by without posting collateral (or having it posted for them).

Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

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