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Wednesday, October 9, 2013

How Not to Manage Foreign Debt Problems

What a relief to read that, back in 2010, there were board members of the IMF who obviously did have experience with countries going through external payments crises and who, therefore, criticized what the IMF and the Troika in general were doing. Not much of a surprise that the critics included board members from Latin America. After all, Latin America had arguably the most experience with national external payments crises and how to handle them.

Since I was personally involved in the external payments crises of Chile and Argentina during the 1980s, I could only marvel about the incompetence I saw displayed at the level of EU leadership beginning in 2010. It prompted me to write the cynical article How Not to Manage Foreign Debt Problems. And I got angry at the arrogance of EU leadership who not only failed to seek advice from those who did have competence but, to top it off, even rejected such advice when it was offered from people like Bill Rhodes & Co. That prompted me to write a most serious article A Nueremberg Trial for EU Elites.

Actually, the nature of an external payments crisis is so simple that a high school student would be able to understand it. All it means is that a country is running out of a currency which it needs but which it can't print. The issue is that is it the country in toto which is facing a sudden stop in the availability of the foreign currency. Put differently, the issue is the entire foreign debt of the country. Whatever happens within the country - be it the public sector, the budget deficit, the sovereign debt, etc. - is of secondary importance.

Now, what might a high school student answer if he is asked his opinion about lenders' attempts to get foreign currency back from a country which has run out of foreign currency and which has a negative foreign currency cash flow at the same time (i. e. current account deficit)? If he is polite, he might say that 'this is like attempting to draw water from a dried-out well'. If he is blunt, he might say that 'this is stupid'.

The Latin Americans could have told the Europeans that the first thing you do is to take the entire existing cross-border debt and reschedule it. The greater the crisis, the farther out the rescheduling of principal maturities (perhaps 25 years; perhaps 50 years; perhaps 99 years; perhaps Evergreen Bonds). And to ease the interest burden, one simply defers interest payments for some time and capitalizes interest (apart from the fact that one should not have fixed interest rates but, instead, rates which adjust to certain macro-economic variables; for example, one could set the interest expense at, say, 5% of total government expenses).

The reason why one reschedules the existing debt (instead of refinancing it) is to keep existing lenders on the hook. The Europeans had the good grace to volunteer their tax payers to pay off existing lenders (without even asking tax payers for approval). Deutsche, BNP & Co. must have opened champagne bottles at the time; the tax payers will sooner or later realize that they paid for the champagne (and much more!).

Terms like 'debt restructuring' or 'PSI' have been used as though they automatically involved a haircut. Well, 'debt restructuring' means that principal and interest maturities are restructured and 'PSI' means that the private sector remains involved (instead of being let off the hook). No more and no less. By misinterpreting these terms as automatically involving a haircut, one scares off everyone and jeopardizes a reasonable solution.

At December 31, 2010, the entire foreign debt of Greece was 404 BEUR (182 BEUR with Central Government and 222 BEUR with Financial Sector and Others). The holders of that debt would have had to be told that they will continue to hold that debt for quite some time to come. At least until such a time when Greece starts generating positive foreign currency cash flows and even then there would only be interest payments and no principal.

Why would the lenders have agreed to such a proposal? For the very simple reason that one cannot draw water from a dried-out well unless someone first dumps the water into it. And it should have been made crystal clear to every creditor that no tax payer can be expected to dump water into the well so that private lenders can take it out for their own benefit. Those creditors who might have refused to accept that would have been invited to make adequate risk provisions to their P+L, check their equity ratios afterwards and prepare to walk over to their governments to ask for a bail-out (and to do that with fitting humility lest the governments don't fire them on the spot).


  1. Simple and clear! I agree completely, it's hard to understand the EU elites myopia.
    Nevertheless, Shauble would say that finally austerity is working well because south is generating current surplus (by cutting imports thanks to kill the consumption) and then generating external cash flow to pay back their debt, despite this debt has climbed.

    1. Oh yes, from the standpoint of foreign creditors, Greece has definitely been a short-term success, namely: as the current account comes into balance, Greece will no longer need Fresh Money, i. e. additional net foreign funding, to stay alive.

      Longer term, even foreign creditors will see that this was only a short-term benefit. One thing is to no longer have to put in Fresh Money. Quite another thing is to have at least the hope that some of the existing debt might be repaid. To use my well-example: eventually, you want to get some water out of the well without first having to dump it into the well, and the only way to get there is by fixing the well. There is only one way to get money back from an insolvent borrower: you have to make him strong again so that he generates cash flow on his own.

  2. Klaus, I understand your anger, but I wonder why you do not see the obvious motives why French and German governments did not accept bankruptcy nor restructuring???

    And slightly shifted but similar reasons still block any attempts for another haircut.

    H. Trickler

    1. Yes, I certainly understand the motives of French/German governments but they were the wrong motives and extremely costly to their tax payers.

      There were two problems and not only one. One was Greece’s insolvency; the other was the dramatic impact which that would have had on lending banks (above all French and German). So they decided to bail out their banks via using Greece’s balance sheet and they called that ‘help for Greece’.

      From 2010-12, 246 BEUR were disbursed to Greece as rescue loans (source: IMF). Of that, 206 BEUR were debt service related; only 41 BEUR were for Greece.

      There is no way that the 41 BEUR could have been avoided unless one had allowed Greece to collapse entirely. Some argue that even more than the 41 BEUR should have been given to Greece to alleviate austerity pressures. I won’t comment on that.

      At issue are the 206 BEUR. In exchange for that, the tax payers got absolutely nothing, and that is the financial crime.

      If the 206 BEUR had been used to recapitalize banks directly instead of via Greece (after forcing them to make loss provisions on their Greek claims), tax payers would have spent the same amount of money but they would have received equity in exchange. And they probably would have recouped quite a bit of that upon the future re-privatizations of those banks.

      PS: for Greece alone, there is no way that the recapitalizations would have had to be as high as 206 BEUR!