In These New Times

Spiegel

24th January, 2011

Despite public denials, euro zone governments are currently working on a proposal to relieve Greek bond debt. The proposal has a number of advantages for all countries involved, but it also entails risks that may be insurmountable. Some believe regulatory pressure will be required to force banks to take voluntary losses on their loans to Athens.

German Chancellor Angela Merkel’s economic advisors — Jens Weidmann and Finance Ministry State Secretary Jörg Asmussen — spent a good part of their working time placating and reassuring their colleagues in Europe.

No, Germany was not striving to restructure Greece’s debts, they told nervous officials calling in from other European capitals. Of course the German government was confident that the reform measures taken by the beleaguered country were working, they said. The cause of the concern had been media reports that Greece wants to buy back part of its debts — at a discount, of course. The action would represent a marked change in the way the crisis has been handled until now. And it would lead to precisely the result that the governments of the 17-member euro zone, the European Commission and the European Central Bank have desperately sought to avoid since the outbreak of the debt crisis.

For the first time, the euro rescue would actually cost real money. Greece’s creditors would be called on to forgive part of the country’s loans; and banks and other investors who have loaned money to the highly indebted nation through government bonds might have to seek government aid again themselves.

A Fund Built on a Major Illusion

So far, the euro rescue fund has only involved pledges and loan guarantees, albeit on a gigantic scale. And it has also been built on a major illusion: The governments, Germany above all, underwrite loans that are provided to troubled euro zone member states. In the meantime, those countries would balance their budgets, and in the end they would pay back their bond debts in full. Thanks to the interest premiums placed on those loans, the euro rescue fund actually makes money for the lenders. At least that was the way German Chancellor Angela Merkel of the conservative Christian Democratic Union (CDU) and other European leaders have envisaged the rescue measures.

Euro member countries and the European Commission stitched together an aid package for Greece overnight in early May last year. A short time later, they prepared a bailout fund for other stricken euro-zone member countries, the so-called European Financial Stability Facility (EFSF).

Nine months and two bailouts later, doubts are growing over whether these measures will actually suffice to prop up the ailing euro. The distrust that these efforts were supposed to remove is instead growing and indeed spreading. After Greece and Ireland, Portugal and Spain are now looking shaky — they have become the possible next candidates for bailouts. It almost looks as if the rescue mechanism is intensifying the crisis rather than eliminating it. This is because just as soon as a country has been rescued, investors’ attention is then steered towards the next weakest country in line. Compounding these issues is a fundamental credibility problem. No one truly believes that, after the aid measures expire in 2013, a country like Greece will ever be able to pay back its debts entirely on its own.

No wonder, then, that the calls for alternatives are growing. Britain’s Economistmagazine ran a cover story last week titled, “The Euro Crisis: Time for Plan B,” and recommended that Europeans should no longer stand back, aghast, at the idea of restructuring debts for ailing states. Even the countries that received aid from the euro rescue fund have in recent days begun to doubt the effectiveness of those measures. Last Monday, Greece’s deputy prime minister aired the possibility of an extension on the payback deadline for the loans — a proposal he quickly denied having made.

Voluntary Debt Forgiveness

Defenders of the current arrangement of the rescue fund have been sticking to the status quo, at least in their public comments. “I don’t know where this news is coming from,” EFSF chief Klaus Regling innocently claimed last week. But Regling knows exactly who is behind the plan. A few weeks ago, he proposed a voluntary debt forgiveness on Greek bonds to officials in the euro zone capitals and to the European Commission. The response to his proposal was by no means as negative as the public statements by officials in the member states had suggested. “That’s a good idea,” said a senior official in the German Finance Ministry, confidentially, in response to the proposal.

Regling’s proposal does indeed have advantages. It offers two simultaneous benefits. It would ease the burden on the Greek budget and, more importantly, it wouldn’t frighten off investors.

The reason is simple: The measure would be voluntary. Creditors would not be forced to forgive debts. Instead, they would be given an offer that they could either accept or reject.

And here’s how Regling’s plan would work: At the moment, Greek state securities are being traded at a sizeable discount to their face value. A five-year bond, for example, is being traded at around 70 percent of its face value — sometimes a little more, sometimes a tad less. Under the plan, in order to improve its debt position, the Greek government would offer to buy back securities from its creditors at a premium over the current market price. The transaction would be backed by the EFSF.

Investors would now face a choice: If they were to accept the bonds, then they would have to book a considerable loss. At the same time, they would have certainty that the losses would not be even greater.

But they could also reject the offer in the hope that, when the bond matures, they will get more money back, maybe even the full face value. But they would risk losing money if Greece did end up becoming insolvent.

EFSF Would Provide Loans for Buyback Plan

But where would Greece get the money for such a buyback scheme? This is where the EFSF would come in. It would give the country a credit line, and Greece would benefit because the interest on the EFSF credit would be lower than the interest rates on its regular bond issues. In addition, the repayment periods would be more favorable. Ultimately, it would give Greece more breathing room.

One variation of the plan would call for Greece itself to raise the money for the operation by issuing new bonds. These would be guaranteed by the EFSF and would therefore have much better credit ratings than Athens could muster on its own. The Greek government’s borrowing costs would be lower. Regardless which model is ultimately favored, Greece would be given additional leeway.

Regling has already proven once before that his idea works. During the mid-1980s, he worked at the International Monetary Fund (IMF) in Washington and Jakarta, where he developed a similar procedure for rescuing the Philippines from a financial emergency. The attempt succeeded and the government in Manila was able to reduce the country’s debt burden with aid from IMF loans.

Nevertheless, a number of preparations would be needed before the Manila model could be applied in Europe. For one thing, the EFSF would need to be able to actually mobilize the €440 billion placed at its disposal by the euro-zone countries. At present, much of that money is needed as a cash reserve so that the EFSF can maintain top credit ratings.

In order to free up the money, the six member states that also have the highest credit rating (including Germany), would need to provide additional guarantees, according to the proposal. Countries with lower credit ratings would have to contribute cash to the EFSF.

There is a good chance that Regling’s plan will be implemented — and possibly as soon as the next summit of EU leaders in March when euro-zone countries plan to agree on additional responsibilities for the EFSF. One plan drafted by the staff of European Commission President Jose Manuel Barroso explicitly calls for bond buybacks.

The euro group of finance ministers debated the proposal on the sidelines of their meeting at the beginning of last week, and it proved popular. “It would be wrong to create taboos,” the chairman of the euro group, Luxembourg Prime Minister Jean-Claude Juncker said in an interview with SPIEGEL.

The finance ministers refrained from striking the proposal from the catalogue of ideas under consideration. That would have been foolish because buying back bonds at a discount would enable a country to quickly scale back its liabilities.

Economists have also welcomed Regling’s idea. “Greece is so highly indebted that it will find it hard to stabilize its debt level in relation to its gross domestic product on its own,” says Jörg Kraemer, the chief economist at German bank Commerzbank. “So it would be possible for states to partially forgive Greece’s debts by supporting it in buying back bonds.”

Part 2: Why Banks May not Comply with Offers

The swapping of older government bonds for new ones with a lower face value is nonetheless a daring proposal. A restructuring of debt would move the EU into previously uncharted territory. Of course, debt restructurings have taken place at different places all around the world. But Greece would be the first country within a currency union to have to restructure its debts.

One potential model from recent decades was the issuance of so-called Brady Bonds in the United States in 1989, which ended a lengthy bank crisis that originated in the 1970s. At the time, American banks had lent considerable money to Latin American countries that Mexico, Brazil or Venezuela were later unable to repay.

Nicolas Brady, who was Treasury Secretary at the time, helped both indebted nations and banks by using the same trick that the Europeans now want to try out. The banks could exchange their liabilities for lower-interest securities, or Brady Bonds, which were underwritten by the US government.

As clever as the idea of a voluntary debt restructuring of Greece and possibly other euro states like Ireland and Portugal may appear, though, it remains questionable whether enough creditors could be lined up who would be willing to go along with it.

Voluntary Debt Forgiveness Could Hit Already Weak Banks

Government bonds from Greece, Portugal and Ireland are already part of the investment portfolios of hundreds of European banks, insurers and pension funds. German credit institutions alone have €29 billion in Portuguese bonds, €27 billion in Greek government securities and €109 billion in Irish government bonds. And those risks are most concentrated in precisely those banks which are already being supported by the government.

At the beginning of the crisis in Greece, German bank HRE, which has since been propped up with €100 billion in German government money, had bonds from Athens totaling €7.9 billion on its books. Meanwhile, partially nationalized Commerzbank had €3 billion in Greek bonds. If banks were to forgive that debt, they themselves may need to turn to taxpayers for yet another bailout. That is why economists are saying that the most urgent task is to render the financial sector more resilient to crises. “The banks must get enough capital to be able to withstand writedowns due on state bonds,” says Kai Konrad, director of the Max Planck Institute in Munich and chairman of the academic advisory board to German Finance Minister Wolfgang Schäuble (CDU).

Many investors may lack the incentive to engage in bond exchanges voluntarily. This is due to current accounting rules under which banks only have to write down the value of securities in their portfolios if they decide to trade them on the market. Government bonds that they want to keep in their portfolios right up to maturity do not need to be written down.

Instead of exchanging ailing existing bonds for secure new ones with a lower face value, banks might instead speculate that the value of the bonds they possess could still be exchanged at face value when they mature. In the run-up to planned stress tests this spring with which the EU wants check how resilient Europe’s banks are to a new crisis, the exchange of Greek bonds would not yield any advantages for many banks.

That would only change if regulators forced the banks to write down their bond holdings. “Without mild pressure from regulators, many banks will not comply with a voluntary exchange offer,” says Thomas Mayer, chief economist at Germany’s leading bank, Deutsche Bank.

Support in Berlin

Despite the risks it entails, the debt restructuring plan has a number of supporters in Berlin — including, for example, the Council of Economic Advisors to Chancellor Merkel’s party, the CDU. Council President Kurt Lauk is calling for a fresh start in euro rescue efforts that would include a European Monetary Fund and a stronger harmonization of economic policies in the countries that have adopted the euro. He believes that debt restructurings should take place as quickly as possible in Greece, Ireland and Portugal. “We need these three countries to make a clear move,” Lauk says.

Clemens Fuest, a financial expert at Oxford University, is calling on politicians to take a more realistic view of the situation. “We need to accept the fact that Greece and Ireland are bankrupt,” he says. Fuest believes there are only two ways to bring the crisis back under control: Either the financially strong countries must assume part of the debt of those countries in trouble, or creditors should forgive part of the debt. “But in that sense it would be better if the affected countries begin restructuring on their own.”