The eurozone crisis is reaching its climax. Greece is insolvent. Portugal and Ireland have recently seen their bonds downgraded to junk status. Spain could still lose market access as political uncertainty adds to its fiscal and financial woes. Financial pressure on Italy is now mounting.
By 2012, Greek public debt will be above 160% of GDP and rising. Alternatives to a debt restructuring are fast disappearing. A full-blown official bailout of Greece’s public sector (by the International Monetary Fund, the European Central Bank, and the European Financial Stability Facility) would be the mother of all moral-hazard plays: extremely expensive and politically near-impossible, owing to resistance from core eurozone voters – starting with the Germans.
Meanwhile, the current French proposal of a voluntary rollover by banks is flopping, as it would impose prohibitively high interest rates on the Greeks. Likewise, debt buybacks would be a massive waste of official resources, as the residual value of the debt increases as it is bought, benefiting creditors far more than the sovereign debtor.
So the only realistic and sensible solution is an orderly and market-oriented – but coercive – restructuring of the entire Greek public debt. But how can debt relief be achieved for the sovereign without imposing massive losses on Greek banks and foreign banks holding Greek bonds?
The answer is to emulate the response to sovereign-debt crises in Uruguay, Pakistan, Ukraine, and many other emerging-market economies, where orderly exchange of old debt for new debt had three features: an identical face value (so-called “par” bonds); a long maturity (20-30 years); and interest set well below the currently unsustainable market rates – and close to or below the original coupon.
Even if the face value of the Greek debt were not reduced, a maturity extension would still provide massive debt relief – on a present-value basis – to Greece as a euro of debt owed 30 years from now is worth much less today than the same euro owed a year from now. Moreover, a maturity extension resolves rollover risk for the coming decades.
The advantage of a par bond is that Greece’s creditors – banks, insurance companies, and pension funds – would be able and allowed to continue valuing their Greek bonds at 100 cents on the euro, thereby avoiding massive losses on their balance sheets. That, in turn, would sharply contain the risk of financial contagion.
Rating agencies would consider this debt exchange a “credit event,” but only for a very short period – a matter of a few weeks. Consider Uruguay, whose rating was downgraded to “selective default” for two weeks while the exchange was occurring, and then was upgraded (though not to investment grade) when, thanks to the exchange’s success, its public debt became more sustainable. The ECB and creditor banks can live for two or three weeks with a temporary downgrade of Greece’s debt.
Moreover, there would be few holdouts that refuse to participate in the exchange. Previous experience suggests that most hold-to-maturity investors would accept a par bond, while most mark-to-market investors would accept a discount bond with a higher coupon (that is, a bond with a lower face value) – an alternative that could be offered (and has been in the past) to such investors.
At the same time, the best way to contain financial contagion would be to implement a pan-European plan to recapitalize eurozone banks. This implies using official resources like the EFSF not to backstop an insolvent Greece, but to recapitalize the country’s banks – and those in Ireland, Spain, Portugal, Italy, and even Germany and Belgium that need more capital. In the meantime, the ECB must continue to provide unlimited resources to banks under liquidity stress.
To reduce the risk of financial pressures on Italy and Spain, both countries need to press ahead with fiscal austerity and structural reforms. Moreover, their debt could be ring-fenced with a larger package of EFSF resources and/or with the issuance of Eurobonds – a further step towards European fiscal integration.
Finally, the eurozone needs policies to restart economic growth on its periphery. Without growth, any austerity and reform will deliver only social unrest and the constant threat of a political backlash, without restoring debt sustainability. To revive growth, the ECB needs to stop raising interest rates and reverse course. The eurozone should also pursue a policy – partially via looser monetary policy – that weakens the value of the euro significantly and restores the periphery’s competitiveness. And Germany should delay its austerity plan, as the last thing that the eurozone needs is a massive fiscal drag.
The eurozone’s current muddle-through approach is an unstable disequilibrium: kicking the can down the road, and throwing good money after bad, will not work. Either the eurozone moves toward a different equilibrium – greater economic, fiscal, and political integration, with policies that restore growth and competitiveness, including orderly debt restructurings and a weaker euro – or it will end up with disorderly defaults, banking crises, and eventually a break-up of the monetary union.
The status quo is no longer sustainable. Only a comprehensive strategy can rescue the eurozone now.
By 2012, Greek public debt will be above 160% of GDP and rising. Alternatives to a debt restructuring are fast disappearing. A full-blown official bailout of Greece’s public sector (by the International Monetary Fund, the European Central Bank, and the European Financial Stability Facility) would be the mother of all moral-hazard plays: extremely expensive and politically near-impossible, owing to resistance from core eurozone voters – starting with the Germans.
Meanwhile, the current French proposal of a voluntary rollover by banks is flopping, as it would impose prohibitively high interest rates on the Greeks. Likewise, debt buybacks would be a massive waste of official resources, as the residual value of the debt increases as it is bought, benefiting creditors far more than the sovereign debtor.
So the only realistic and sensible solution is an orderly and market-oriented – but coercive – restructuring of the entire Greek public debt. But how can debt relief be achieved for the sovereign without imposing massive losses on Greek banks and foreign banks holding Greek bonds?
The answer is to emulate the response to sovereign-debt crises in Uruguay, Pakistan, Ukraine, and many other emerging-market economies, where orderly exchange of old debt for new debt had three features: an identical face value (so-called “par” bonds); a long maturity (20-30 years); and interest set well below the currently unsustainable market rates – and close to or below the original coupon.
Even if the face value of the Greek debt were not reduced, a maturity extension would still provide massive debt relief – on a present-value basis – to Greece as a euro of debt owed 30 years from now is worth much less today than the same euro owed a year from now. Moreover, a maturity extension resolves rollover risk for the coming decades.
The advantage of a par bond is that Greece’s creditors – banks, insurance companies, and pension funds – would be able and allowed to continue valuing their Greek bonds at 100 cents on the euro, thereby avoiding massive losses on their balance sheets. That, in turn, would sharply contain the risk of financial contagion.
Rating agencies would consider this debt exchange a “credit event,” but only for a very short period – a matter of a few weeks. Consider Uruguay, whose rating was downgraded to “selective default” for two weeks while the exchange was occurring, and then was upgraded (though not to investment grade) when, thanks to the exchange’s success, its public debt became more sustainable. The ECB and creditor banks can live for two or three weeks with a temporary downgrade of Greece’s debt.
Moreover, there would be few holdouts that refuse to participate in the exchange. Previous experience suggests that most hold-to-maturity investors would accept a par bond, while most mark-to-market investors would accept a discount bond with a higher coupon (that is, a bond with a lower face value) – an alternative that could be offered (and has been in the past) to such investors.
At the same time, the best way to contain financial contagion would be to implement a pan-European plan to recapitalize eurozone banks. This implies using official resources like the EFSF not to backstop an insolvent Greece, but to recapitalize the country’s banks – and those in Ireland, Spain, Portugal, Italy, and even Germany and Belgium that need more capital. In the meantime, the ECB must continue to provide unlimited resources to banks under liquidity stress.
To reduce the risk of financial pressures on Italy and Spain, both countries need to press ahead with fiscal austerity and structural reforms. Moreover, their debt could be ring-fenced with a larger package of EFSF resources and/or with the issuance of Eurobonds – a further step towards European fiscal integration.
Finally, the eurozone needs policies to restart economic growth on its periphery. Without growth, any austerity and reform will deliver only social unrest and the constant threat of a political backlash, without restoring debt sustainability. To revive growth, the ECB needs to stop raising interest rates and reverse course. The eurozone should also pursue a policy – partially via looser monetary policy – that weakens the value of the euro significantly and restores the periphery’s competitiveness. And Germany should delay its austerity plan, as the last thing that the eurozone needs is a massive fiscal drag.
The eurozone’s current muddle-through approach is an unstable disequilibrium: kicking the can down the road, and throwing good money after bad, will not work. Either the eurozone moves toward a different equilibrium – greater economic, fiscal, and political integration, with policies that restore growth and competitiveness, including orderly debt restructurings and a weaker euro – or it will end up with disorderly defaults, banking crises, and eventually a break-up of the monetary union.
The status quo is no longer sustainable. Only a comprehensive strategy can rescue the eurozone now.
Nouriel Roubini is Chairman of Roubini Global Economics (www.roubini.com), a professor at the Stern School of Business at NYU, and co-author of Crisis Economics.
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