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Stop Avoiding Euro Debt Restructuring: Choudhry

Sovereign debt default is a sensitive area for investors. Defaults by developed country borrowers are rare beasts, and investors have long memories (after the Argentina default in 2001, it was 10 years before the government could tap the capital markets again for funds).

Combine a number of countries into a currency union, and the voices of those proclaiming that sovereign default is akin to the arrival of the four horsemen of the apocalypse get louder.

Stacks of 5-Euro bills
AP
Stacks of 5-Euro bills

That said, notwithstanding Mr Keynes' possibly apocryphal "in the long run we're all dead", even in the medium term putting off default can end up being more painful than biting the bullet and restructuring now. Consider what's been happening in the southern euro zone since the onset of the banking crash.

Each new initiative, starting with successive government assurances, the creation of the financial stability fund, increasing the size of the fund, asking for a bailout, and so on, merely buys time (about 4-6 months, it would appear). The crisis rumbles on inexorably, with the additional fear of contagion.

Meanwhile the debt burden in those countries suffering a fiscal policy crisis continues to increase, and is so large in some cases that investors are beginning to wonder if it will ever be repaid. Ireland's debt stands at the equivalent of about 20,000 euros ($32,000) per person.

The market's worries on whether such severely indebted countries will ever be able to generate sufficient growth and jobs to bring debt servicing under control remains in place. The end result is that interest costs for such countries rise, and the market lurches from one crisis to the next.

In the meantime these fiscally-challenged economies find themselves in a straitjacket of ever-higher debt service costs, decreasing productivity and still-high labor costs. Even the budget cuts in Greece, while rolling back elements of the welfare state in the traditional IMF-approved manner, will not restore a competitive advantage for some time.

In the past the traditional way to escape budget imbalances was via currency devaluation. This had an immediate cost to the economy but also enabled the devaluing country to regain a measure of productivity, as well as an export advantage, and thereby start registering growth again.

But in a currency union this isn't possible. So what alternative solutions are available? Can default be contemplated?

A default, in or out of a currency union, locks the government out of capital markets for the foreseeable future. However its debt service costs will no longer be a millstone because the debt will have been "restructured", perhaps via an interest payment holiday for a year or two, or a lengthening of loan maturity dates, or both.

This immediately relieves some of the pressure on the fiscal position. This, combined with removal of labor market restrictions ("supply side reforms") and lower labor costs, will assist growth and export competitiveness. This then has the knock-on effect of raising employment. In due course the government's fiscal position will improve, enabling it to return to servicing debt.

Is the above scenario possible by one (or more) members of a currency union? In theory there is no reason why not. It is technically possible for a state or local authority in one country to default, even though it uses the same currency as the rest of the country.

Of course the issue is much bigger in the euro zone, and much more political. But the size of some countries' debt is such that it is difficult to think of their debt burden ever becoming manageable. At some point, no amount of assurance and no increased size of the stability fund will make a difference; investors will conclude that default is inevitable and act accordingly.

Is it perhaps better to announce it as proactive policy, in a more-or-less ordered fashion, than to wait until that apocalyptic moment?
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The author is Dr Moorad Choudhry, Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University