It was a busy week on the Greece sovereign debt crisis front. A quick recap: The Greek debt exchange went ahead, as expected; the result will be the socialization of Greek debt, as private claims are replaced by public sector claims, through EU, ECB and IMF exposure; and credit default swaps will pay out something – although the actual amount is still to be determined. The Financial Times’ alphaville has a good discussion of JP Morgan’s assessment of the implications of all this on Greece’s private bondholders, compliments of Izabella Kaminiska. The bottom line: the future risk of default on private bondholders should be pretty low.
With the bulk of Greek debt now in official hands, and the resources for payments to private bondholders held in escrow accounts, private investors can sleep sound. Right?
Let’s park that thought for the moment and consider what happens with the debt held in official hands. An argument made by those who support efforts to build a better framework for the timely, orderly restructuring of sovereign debt – myself included – is the absence of clarity and consistency (over time, and across different types) on how private claims are treated. Consider the table below, which shows the different institutions for debt restructuring:
There are institutions to facilitate most types of international debt restructuring. ‘Institution’ is broadly defined here to include virtual bodies, such as the London Club, which has no permanent structure, secretariat or legal standing, but operates on an informal basis and convenes “when necessary.” The upper left cell indicates shows that the claims of a sovereign creditor on a private entity can be restructured in domestic bankruptcy courts, as can private claims on private debtors. Similarly, sovereign claims on sovereign debtors are restructured in the Paris Club, whereas private bank claims on sovereign debtors are dealt with in the London Club. The lower right cell of the table suggests, however, a “missing market” in restructuring privately-held sovereign bonded debt.
At present, private bonded claims on sovereigns must be restructured through a “voluntary” debt swap, such as the recent Greek transaction. But with so much of Greek debt now held by official creditors, going forward, future restructuring of Greek, should they be necessary, would be in the Paris Club.
This is where things get interesting.
In the past, official creditors have typically accumulated claims on sovereigns through their export credit agencies, development assistance and agricultural export credits. Such claims are generally not accorded a special priority in the Paris Club. The International Monetary Fund (IMF), in contrast, reflecting its role in assisting countries already in financial difficulty, has traditionally asserted a preferred creditor status, analogous to debtor-in-possession financing in the context of domestic corporate bankruptcy regimes. As a result, the IMF is repaid before other creditors. Of course, if the IMF is paid in full, other creditors may face larger losses on their claims.
In the case of Greece, European official creditors (EFSF, ECB) are asserting a preferred creditor status, parri passu with the IMF. This is a potential problem. Even with the large write downs on private sector claims consummated by the debt swap, Greece faces a long, difficult period of fiscal adjustment. The challenges of adjustment are increased by its severe overvaluation and lack of competiveness, which the Greek Government, ECB and EU propose to address through structural reforms, or internal devaluation.
Such policies take time to work; in the interim, the social and political consensus in Greece will be severely tested. The risk of a default cannot be entirely discounted. If all official creditors are preferred, however, and remaining private sector claims are de minimus and protected by payments held in escrow, there isn’t any debt to reduce should Greece be unable, or unwilling to persevere with adjustment. This suggests two possibilities:
First, if official creditors are unwilling to write down their claims in the Paris Club, Greece could see not option but to default to its official creditors. Regardless of the economic and legal issues that would entail, I’m not sure the politics would allow Greece to remain in the euro zone. In that event, losses to private creditors would once again be on the table.
Second, Paris Club creditors can take a “long view” regarding debt restructuring. In this regard, the strategy might be to reschedule Greek debt over a very, very long horizon – keeping the nominal face value of the debt constant, but extending the maturity of the official debt over, say, fifty years. Provided the net present value of the debt is preserved, this would allow official creditors to credibly assure European taxpayers that they are not suffering losses; it would also reduce the immediate debt servicing burden on Greece. With a sufficiently long time horizon, the beneficial effects of structural reforms would gradually improve the competitiveness of the Greek economy and reduce the risk of an exit from the euro zone.
The second possibility could be an elegant strategy to deal with a complex problem. If it is, in fact, the European strategy, the next act of the Greek drama would be an overture to the Paris Club. Such a referral is not without risk: in particular, it is not clear that northern European taxpayers would be prepared to defer payments over the very long time horizon that might be required to make the strategy work.
In this event, they would do well to consider Europe’s history. At the end of World War II, special provisions were provided to Germany and other former belligerents, including debt forgiveness and a breathing space in which to accede to the obligations of the IMF Articles of Agreement. Moreover, Great Britain, exhausted from almost six years of fighting, was given favourable terms under which to repay her debts to her allies. Canada provided the U.K. with a very large, very generous long-term loan to pay for foodstuff and finance reconstruction. In the context of a possible Greek reference to the Paris Club, it is interesting to note that the last payment on that loan was made only a few years ago.
 The preferred creditor status thus supports the convention that IMF members’ quota subscriptions constitute international reserves and thus do not require fiscal provisioning.