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Friday, September 23, 2011

Default, Bankruptcy, etc.

With so much discussion about technical terms like „default“ or „bankruptcy“ etc., here are some clarifications.

A sovereign state only rarely actually repays its debt in full. Even debt reduction in nominal terms has become a rarity in today’s world. A sovereign state “refinances” its debt. As long as a sovereign state can refinance its debt without difficulties, it is considered solvent. When it loses this ability, it is considered insolvent.

“Default” means that a condition in a loan agreement or public debt instrument is not complied with. Such a condition would be that payments are made on time. Default does not become official by itself; it must be declared by someone, typically a creditor or a rating agency. If a loan goes into default, the lending banks have the flexibility to not declare default even though it has occurred. One reason might be that they are willing to negotiate with the borrower how default could be cured. This flexibility is not available with public debt instruments (but most such instruments include grace periods).

“Cross-default” means that a default in one loan or public debt instrument automatically triggers default in all loans and public debt instruments.

If every borrower who ever entered default would automatically have been declared bankrupt, there would be a lot fewer corporations in the world. Thus, default is not bankruptcy. Instead, it is a condition where the borrower cannot comply with the terms of his debts and where he has to do something about that. Notwithstanding this, when a sovereign borrower goes into default, this is commonly referred to as bankruptcy even though this is not correct.

“Bankruptcy” can only occur when there are bankruptcy laws. There are no bankruptcy laws for sovereign states. A bankrupt corporation disappears when bankruptcy has occurred and after it is wound down (Enron no longer exists). A sovereign state cannot disappear (Argentina still exists).

“Repudiation of debt” is a situation where a sovereign state declares to no longer honor its outstanding debt in full (Argentina). This is the closest which a sovereign state can come to bankruptcy. After debt repudiation, a country is typically excluded from international financial transactions. Creditors would be entitled to put a claim on foreign assets of the sovereign state (i. e. an airplane). In history, this often lead to war.

In conclusion, a sovereign state cannot go bankrupt like a corporation can. It can repudiate its debt but there is no real value gained by the sovereign state through debt repudiation (and great long term cost!). Thus, sovereign states typically remain “in default” when they can no longer comply with the conditions of their debt. If a sovereign state simply remains in default without doing anything about it, the lenders may eventually “deem” the state to have repudiated its debt.

To avoid and/or cure default, a sovereign state needs to consensually reschedule its debt with its lenders, that is renegotiate the maturities of debt and interest payments into the longer term future. Debt rescheduling has nothing to do with the forgiveness of debt (“haircut”).

“Haircut” means that the lenders forgive the sovereign state a portion of its debt. Since a sovereign state cannot disappear like a corporation can, haircuts for sovereign states must be viewed differently than haircuts for corporations.

A corporation must compile a balance sheet. If a positive net worth cannot be shown, bankruptcy would occur automatically. Thus, haircuts with corporations are quite common in order to avoid automatic bankruptcy.

A sovereign state does not compile a balance sheet. Its budget only contains actual incomes and expenses. If interest on debt is not paid (because loan agreements have stipulated capitalization of interest), it does not become an expense in the budget. Thus, if maturities of sovereign debt and interest are rescheduled out to, say, 30 years (and if interest is capitalized), this becomes economically equivalent to a haircut for 30 years. However, the debt obligation remains de jure in place.

A haircut for a sovereign state is the absolute exception and has occurred only infrequently in history. Typically, it is allowed when a country is in an absolutely hopeless situation (poor state and poor population). Examples would be certain countries of the 3rd world. Or, when a country has gone through a devastating one-time destruction (Germany after WWII).

A 3-year financial and economic crisis does not justify a haircut, above all not for a country of the 1st world (Greece, as an EU-member, must be viewed as a country of the 1st world). While the Greek state may indeed be economically bankrupt, the Greek population is not. On the contrary, the Greek upper class is among the wealthiest in the world (albeit most of that wealth is outside the country). Also, the Greek economy has never really utilized its potential. If the Greek economy could find a way to utilize its potential and if at least part of the foreign wealth of Greeks returned to the country, there could certainly be a vision that Greece becomes again a solvent country within 30 years.

When economist argue that 50% of Greece’s debt should be forgiven because the country has no realistic chance to service so much debt, they ought to be saying that 50% of Greece’s debt should be rescheduled out to, say, 30 years and that interest on it should be capitalized. Note that even a country like Mexico, which has its own problems, was able to sell a 99-year bond in capital markets.

The remaining 50% of the debt should be rescheduled in such a way that Greece has “breathing space” (but not too much of it!). Lenders who agree to a debt rescheduling justifiably want assurance that they keep control over the borrower’s performance. Such control is achieved by “structuring” amounts and maturities of interest payments in such a way that the county has breathing space but not so much breathing space that promised reforms are not implemented. Typically, one assesses the amount of interest which a country is deemed to be able to pay annually as a percentage of total expenses and one sets the interest rate accordingly. If that interest is not paid on time (because, for instance, the country has returned to wasting money), one returns to the situation of default.

A possible example how the other 50% of Greece’s debt could be structured: 30% for 20 years with interest capitalized during the first 10 years and the remaining 20% for 10 years with interest payable annually.

The general principle must always be that one cannot draw water from a dried-out well. Greece can only repay her debt in as much as she is first lent new money to do that. A debt rescheduling recognizes this reality.

Once the existing debt is rescheduled, Greece will still need Fresh Money for quite some time. Typically, Fresh Money should come from public institutions (i. e. the EU) whereas the rescheduling involves only the current lenders. Fresh Money must be in a senior position to other debt and it should only be available for the financing of the budget deficit (including interest). The new debt agreements must stipulate that Fresh Money cannot be used for any capital transfers abroad (i. e. capital flight).

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