“When it becomes necessary for a state to declare itself bankrupt, as in the same manner as when it becomes necessary for an individual to do so, a fair, open and avowed bankruptcy is always the measure which is least dishonorable to the debtor and least hurtful to the creditor.”
Adam Smith, The Wealth of Nations
The newly-elected Greek government has taken shape and has already begun to roll back some of austerity measures that had been imposed under the terms of the troika's support package. Having campaigned on an anti-austerity platform and winning a clear, unambiguous mandate, it could, arguably, do no less. That is what democratic government is all about.
Democracy requires a modicum of political maturity, however. If the Greek people want to unilaterally reduce the debt burden, they must be prepared to live with the consequences. And, by the same token, if other members of the euro zone refuse to parley, they too must be prepared for the consequences. That simple fact is that debt is a promise; sovereign debt a conditional promise — no more, no less.
Debt restructuring is necessarily, therefore, a negotiation.
That is not to say that the process of renegotiation will be smooth, orderly and utterly devoid of disruption. "Prediction is very difficult," as Neils Bohr quipped, "especially if it is about the future." But a prognostication that the coming debt negotiations will feature at least some degree of turbulence, disorder and cost strikes me as a pretty safe bet.
The speed with which the Greek government has acted and its declaration that it will not negotiate with the troika could be viewed as recklessness, as some have suggested. Or, it could be an "open and avowed bankruptcy” in the spirit of Adam Smith. Regardless, it is likely part of a strategy of pre-commitment in coming debt restructuring. The outcome of those negotiations is still to be defined. But, by abrogating the terms of the troika agreement, the Greek Government is, in effect, pre-committing to a strategy that excludes minor tinkering with the status quo.
That might be a good negotiating tactic. I don't know. It is clear, however, that the next six month or so will not only be critical to the Greek people, but also to the euro zone, financial integration and global governance.
What are the issues?
Most obviously, is the size of debt reduction. The Syriza party campaigned on a platform of reducing the debt burden, arguing that the terms of the troika-led "rescue" package were more about protecting banks in Germany and other creditor countries. Three years on, the banks have had time to recapitalize and the entire euro zone banking system has been subjected to a second (and this time, more credible) round of stress tests. But in that time, the Greek debt-to-GDP ratio rose steadily.
A number of commentators, including Lorenzo Bini Smaghi, have pointed out that the face value of debt can give a misleading impression. That is exactly right. The terms of the debt — its maturity and the coupon rate establishing periodic payments on the debt — are key factors determining the underlying economic value of the debt. There is a third factor, however, the rate at which future payments are discounted, which is equally important. The discount rate can be thought of as the opportunity cost of holding the bond — private investors with alternative investment opportunities offering, say, 10% will price the bond using that rate to discount current and future payments on the bond. For any given coupon payment and maturity, the higher the discount rate, the lower the price.
To see this point, consider the following table, which gives the net present value (NPV) of a $100 bond priced with a 10% discount rate. With a coupon rate of 10%, the investor will pay the issuer the full face value of the bond, regardless of the maturity of the bond. If the coupon rate is lower than the discount rate, however, say, 5% or 1%, the amount the investor offers is less than the face value of the bond. Moreover, the longer the maturity, the lower the NPV. As Table 1 shows, this effect can be dramatic: with a 1% coupon rate, the NPV of $100 bond maturing in 50 years is only $11; with a 5% coupon rate, the comparable value is $50. So, while the face value of debt may be high — $100 in both cases — the underlying economic valuation is considerably lower. Of course, it is possible to secure even greater upfront relief by forgoing any interest payment for an initial period.
Table 1: Net Present Value ($100 face value, 10% discount rate)
This gap between the face value and the net present value of a bond creates an opportunity for creativity in debt restructuring. Consider the restructuring of a hypothetical bond in Table 1 initially issued with a 10% coupon rate (equal to the discount rate) and a 10 year maturity. The NPV of the bond is $100, exactly equal to the face value. Assume that the sovereign issuer, pleading bankruptcy, proposes to cut the coupon rate to 1%. Instead of annual coupon payments of $10, the issuer’s payments would fall to $1. The proposed restructuring would reduce the NPV to $48 — equal to about half the face value of the bond, which the issuer asserts is the minimum degree of debt relief it requires. The bondholder might agree. But what if the bondholder balks at the proposed restructuring, citing the need for income? Well, the sovereign could offer a restructured bond that offers a 5% coupon rate (to provide $5 in annual income to the bondholder) with a longer maturity. With a 50 year maturity, the 5% coupon bond would provide the same degree of debt relief as measured by NPV.
This approach might succeed if the bondholder agrees that a 50% debt reduction is needed. But more likely than not, this will be the key issue in dispute. As Paul Krugman argues, here, the gross stock of debt is meaningless. What matters is the flow of resources that the sovereign is prepared to pay to its creditors. This is the real battle ground for debt restructurings.
In a sense, debt restructuring can be viewed in terms of determining the value of a single parameter β, defined as the share of total output that is to be transferred to foreign creditors, where 0 ≤ β < 1. It is clear that the lower bound is given by zero, as the sovereign borrower could choose not to transfer any resources. Similarly, the upper bound is less than one (full transfer of resources) since that would imply that all of the country’s output is appropriated for servicing foreign claims; in this respect, democratic government imposes constraints on the size of transfers that can be made to foreign creditors. If all the returns from production go to foreign creditors, citizens might be forgiven for asking — why bother producing? Similarly, while structural reforms are aimed at increasing the productive capacity of the economy over time, they entail upfront costs; if the benefits from structural reforms accrue to foreign creditors, citizens might also ask why bother? At the limit, sovereign debtors subject to democratic institutions will not transfer more, say, than is required for minimal nutrional requirements. (Note that this rule clearly did not apply to Ceausescu’s authoritarian regime in Romania). Beyond those boundaries, the restructuring is the outcome of a bargaining game.
A number of factors come into play. Governments are likely to plead penury; hoping to convince creditors to accept lower transfer. Creditors, meanwhile, may over-estimate the growth capacity of the economy and hence the ability of the government to generate revenues for debt servicing. The rate at which sovereign borrowers and their creditors discount the future plays a big role in the process. Far-sighted societies will weigh the short-term costs of transferring resources to foreign creditors against the benefits of maintaining access to credit markets to finance investment and smooth consumption; myopic governments will discount the future more heavily, reducing their willingness to make transfers. The impact of a change in discount rate is shown by comparing the NPV of different hypothetical bonds in Table 2, calculated using a 5% discount rate with the results of Table 1.
Table 2: Net Present Value ($100 face value, 5% discount rate)
With a 5% discount rate, the initial restructuring proposed by the sovereign borrower, entailing a reduction in the coupon rate from 10% to 1%, results in a NPV of $72. While still representing a substantial reduction in their claims, this is a far less painful than the “haircut” calculated using a 10% discount rate. This effect may help explain why sovereign debt restructurings between 2002 and 2012 were relatively smooth and orderly, with one notable exception, compared to earlier restructurings. The decline in global interest rates in the wake of the dot.com bubble may have greased the wheels of the debt restructuring process as debt issued under a high(er) interest rate environment was rescheduled in a low(er) rate world.
The coming negotiations between Greece and the rest of the euro zone are likely to be manic depressive. It is encouraging that the Greek government has thus far acted in a calm and deliberate manner; and not unexpected that the German finance minister has not conceded any ground. In the coming days and weeks positions may shift, but the basic issue at stake will be the level of resources that the Greeks can transfer.
This is an issue, obviously, for Europe. But it is an issue that could affect all. Protracted uncertainty over the outcome of the negotiations and the future of the euro could propagate stagnation, as firms and households exercise the option value of waiting — holding back on investments and purchases. This would not be helpful in a global economy characterized by insufficient global aggregate demand and deflationary pressures.
In this respect, the failure to construct an effective framework for sovereign debt restructuring and to ensure the IMF is capable of assisting its members to achieve a judicious balance between financing and adjustment could result in the fragmentation of the global economy. Capital flows may dry up for all but the most credit-worthy borrowers and governments may resort to trade protectionism in an ill-conceived and mutually-destructive attempt to beggar-thy-neighbours. All of that would entail the loss of the greatest engine of development and global poverty reduction yet devised.