Monday, May 14, 2012

Wolfgang Muenchau is incomplete!

Wolfgang Muenchau (who writes for FT, FTD and Der Spiegel) has written an article titled “Default now or default later?” In it, he outlines 4 alternatives which he sees. None of them is perfect but the least bad one is for Greece to wait until it has achieved a primary surplus and then default (sometime in 2013). Muenchau is receiving accolades for this.

Muenchau recently attended the INET-Conference in Berlin but he probably did not stick around to hear the conference’s last speaker, Prof. Andres Velasco, former Finance Minister of Chile. One of Prof. Velasco’s themes was that economists, journalists, etc. do not have to come up with brilliant new ideas for the solution of the EZ’s financial challenges. It would suffice if they only learned from past experiences which others have had (like Latin’s).

Muenchau writes like he has never been involved in a debt restructuring. He suggests a country’s default means the exclusion from any further financing. Therefore, a country should not default before it has a primary surplus. Furthermore, he tacitly suggests that a country’s external payments problems can be solved by only solving its sovereign debt.

Greece, for one, has more or less been excluded from capital markets for at least the last 2 years (with the exception of occasional short-term tenders). Put differently, Greece has been financed by official institutions (Troika, ECB) since then. Official institutions can always finance if there is the political will to do so; before or after a default.

If all countries which ever had to restructure their debt had waited for a primary surplus before initiating the process, much of the world’s sovereign debt would be in default today. A primary deficit is no hindrance for a restructuring, it is part of the package and it is called Fresh Money Requirement!

Furthermore, to only consider sovereign debt when restructuring a country’s debt is incomplete! It is the entire foreign debt which must be restructured, i. e. the foreign debt of the state, the banking sector and other sectors of the economy (if one wants to restructure the domestic portion of sovereign debt as well, fine, but that is not mandatory). Above all, the trade credit lines for the banking sector must be confirmed so that the country can handle its foreign trade.

The question of interest
The first point which must be recognized is that the only thing which matters for the budget is the cash interest which is paid. Any interest which is capitalized to be paid in cash later does not burden the budget. It is ridiculous to think that a country with external payment problems should pay cash interest at more or less market rates. Why? Because, by definition, a primary deficit means that the country needs to borrow money to pay interest. That may be acceptable during “normal” times but it is absolutely ridiculous during a sovereign restructuring. It would be like attempting to get water from a dried-out well. One first has to dump the water in it!

Thus, it is less the nominal interest rate which matters but primarily the amount of it which is payable in cash (the rest being capitalized). Should that be zero? In extreme situations it could be for a limited period of time. For example, one could honor Greece for its austerity so far by, say, capitalizing all interest for a year or two.

Whichever way one handles the restructuring, there is no limit to creativity under one condition: it all needs to be handled consensually!

To make unilateral declarations of what one will do (or will not do under any circumstances), such as declaring a moratorium, is amateurish. Argentina thought it could do that over a decade ago because that country is rich in natural resources and typically has trade surpluses. They repudiated part of their foreign debt. Well, they still do not, over 10 years later, have normal access to capital markets!

Why would lenders agree to a capitalization of interest, a restructuring of maturities way into the future and even the making available of Fresh Money? Because they really don’t have much of a better alternative (except cutting Greece off from all funding). Will all that restructured debt and interest ever be paid? Probably not. Sovereign debt only rarely gets “repaid”; it always gets “refinanced”. Will foreign creditors ever get 100% of their claims? Probably not. But even if they only get 10% of it, it is still better than agreeing to a 100% haircut. Apart from the fact that a haircut on sovereign debt for a country of the First World is probably the worst thing one can do.

Some may now say “yes, but you describe a consensual restructuring; we are talking about a default”. True and false. There is only one reason why sovereign debt gets restructured and that is because otherwise there would be a default. If technical default occurs during an ongoing, constructive and consensual process of debt restructuring, it is quite acceptable.

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