It is customary at the start of a new year to look forward and think about the year ahead. With concern over weakening growth in China and a possible significant depreciation of the Renminbi, Brazil being in the worst economic downturn since the Great Depression and other emerging market economies fearful of a "sudden stop" or capital flow reversals in the wake of Fed tightening, there are undoubtedly a number of clouds on the horizon — and these are merely the obvious challenges in the global economy. In some respects they are overshadowed by geopolitical risks: Chinese ambition to extend its sphere of influence, if not its sovereignty, in the South China Sea; North Korea's destabilizing nuclear pretensions; Russia's continuing march backwards; and new spheres of uncertainty in the Middle East. On the bright side, the Paris Climate Change accord provides some grounds for optimism that the international community can come together to address global challenges.
A forthcoming post will address the challenges that lie ahead. First, however, a look back.
A year ago, I identified three challenges for 2015. At the time, I thought that the year might have been the "year of restructuring dangerously." It was clear that sovereign debt loads in a number of countries were high, rising and in all likelihood unsustainable. Debt restructuring was clearly coming; the question was whether they would be relatively orderly or dangerously disruptive. The immediate problem, of course, was Greece and the election of a party with a very clear mandate to reduce the debt burden and relieve the strain of "internal adjustment." But also on the horizon were the unsustainable debt burdens of Ukraine and Puerto Rico.
The first half of 2015 was indeed dominated by Greece and Syriza's attempts to renegotiate its arrangements with the troika. Invoking the threat of default, the Greek government played a game of chicken with its European partners (de facto the German Finance Minister). As things turned out, at least on face value, it was the Greeks who yielded and, after much gamesmanship, the program looks pretty similar to the program before Syriza's election. Appearances, however, can be deceiving.
From the Greek debacle came a very important development in sovereign debt restructuring. The IMF made it clear that it would not lend into a situation of unsustainable debt; one in which, presumably, the promised policy actions needed to ensure sustainability are not credible. The importance of this is that access to IMF resources can condition the willingness of private creditors to contemplate an orderly write down of claims and the readiness of sovereign borrowers to discuss the need for a timely, orderly restructuring (a rescheduling — not necessarily a NPV reduction) before a problem morphs into a crisis. While this has in fact been IMF policy for some time, the application of "exceptional circumstance" provisions has allowed the Fund to ignore the admonition, if deemed necessary. Going forward, the Fund seems intent on exercising a more vigorous application of the rule.
This was likely the case in the restructuring of Ukraine's debt, which in some respects was free of the gamesmanship that marked the Greek negotiations. The IMF conditioned expectations very early in the process; so, while private creditors were indubitably very unhappy with the prospect of a significant haircut, a large NPV reduction was achieved relatively quickly and without disruption. To be sure, geopolitics was involved — not surprising given Russian financial claims and efforts to exert its "influence" and reorient Ukraine's foreign policy. In what could be viewed as a slightly surreal act of Realpolitik, Russia is suing Ukraine for unilaterally restructuring its claims. Perhaps Moscow will seek the advice of Argentina's holdout investors. Despite this year-end legal gambit, Ukraine demonstrated that restructuring sovereign debt need not be messy.
This is unlikely to be the case with Puerto Rico. The US dependency has by most accounts an unsustainable debt burden. The debt cannot be repaid as contracted; some restructuring is inevitable. Yet, it can neither draw on IMF assistance, not being a sovereign state and member in its own right, nor can it rely on Chapter 9 of the US Bankruptcy code as states facing severe financial distress are able to do. Instead, it’s caught in a type of legal limbo.
The situation is actually more depressing than that. As a superb article in The New York Times pointed out prior to Christmas, the hedge funds that hold a large chunk of Puerto Rico's bonds have lobbied Congress to prevent the island territory from gaining access to a legal framework to promote an orderly restructuring. The only option, they seemingly say, is "repay the debt regardless of the consequences." The problem is that taxes can only be raised so high and benefits reduced so far before people realize that they could do better elsewhere. That means moving to the continental US. The dynamic now in place is a debt burden "owed" by a shrinking population; as people leave, however, output falls so that the debt burden rises ever higher. That situation obviously can't go on forever. It won't.
Similarly, while relative calm has returned to the Eurozone, the Greek debt burden remains high and, absent a very long-term rescheduling akin to that provided to the allies' protagonists after WWII that reduces debt-servicing burdens, Greek economic prospects balance on a knife edge. Stronger growth in the Eurozone, which seems possible given the efforts of Super Mario to resuscitate European banking and some relaxation of fiscal austerity, would clearly help. But the politics of internal adjustment are difficult and the risk of another round of gamesmanship cannot be discounted. Recent elections in Spain, which produced an inconclusive outcome, highlight the political consequences of internal devaluation that frays the social fabric.
Meanwhile, Russian claims on Ukraine and the legal proceedings it has initiated in London could break new ground in the sovereign debt restructuring field. Expect to hear more — possibly much more — about odious debt in the months ahead.
The upshot of all this is that 2016 will continue to be a year of restructuring dangerously. And some of the new year risks may be the old year challenges.