by Don Alexander, MBA
Associate, RSD Solutions Inc.
Alessandro Leipold, a former IMF Director for Europe, wrote an interesting e-commentary for the Lisbon Council called Thinking the Unthinkable: Lessons of Past Sovereign Debt Restructurings. The main message was that the longer policymakers delay the inevitable, the greater the potential loss of economic output and the greater the amount of good money that will be thrown after bad in the form of higher bailouts. The result is higher potential losses for bondholders in the form of haircuts. The real problem is the capital shortfall of European banks relative to their exposure to peripheral European countries. It will become more problematic unless they admit to potential problems. Policymakers continue to treat it as a liquidity problem not solvency.
Sovereign debt restructurings – in the form of either negotiated agreements or outright unilateral defaults – have been around the global financial system for centuries. The spreading contagion, due to policymaker’s weak response, has forced from one of outright denial to recognition of the need “ private-sector involvement” – another way to say debt restructuring – as part of the solution. The author draws on five lessons from past restructurings: (1) avoid detrimental delays, (2) repair the banking system, (3) remove politics, (4) stay ahead of the curve with pre-emptive exchange offers, and (5) do not expect too much from collective action clauses. The key focus is on the debt restructuring process itself, the need for a sense of urgency and the inclusion of all interested parties to avoid political delay.
The attention to prompt action helps to reduce financial market uncertainty and provide greater transparency to investors. There is a need for policymakers to deal promptly with the bank exposure and capital shortfall and to address any unsustainable debt situation. The current prescription by the European policy makers to provide a short-term liquidity facility or medium-term stability funding is not working. For example, the banking system does not receive the long-term funding or new capital injection required. Instead, they get a guarantee from their own government, which has its’ own poor credit. The risk in delay is the higher cost of the bailout and greater potential losses for bondholders.
For more on Alessandro Leipold’s thoughts on sovereign debt click on the link:
Note: During the week of May 9, 2011, Greek government debt Credit Default Swaps (effectively a form of debt “insurance”) reached record high prices.
