Busch: Why Greece Will Restructure and What Form it Will Take
The European debt crisis continues to remain headline material and continues to negatively impact the financial markets.
This is happening despite the efforts of the ECB, the IMF and the European Union to reform the periphery and to provide liquidity to those sovereign nations.
Greece is the linchpin for a solution and resolution of the crisis. The essential element missing is this: how to do a Greek debt restructuring. Let's review what's happened and what could happen given the rich history of global debt restructuring.
There are two paths that Europe can go down to deal with Greece, Ireland and Portugal. The first is the one they are currently on and has not solved the problem. The IMF, the ECB and the EU have provided significant funds to all three nations to alleviate the need for them to refund themselves via the global capital markets. With interest rates soaring and private capital shunning the debt due to rating agency downgrades, these nations are unable to fund themselves at current rates. Sadly, they are unlikely to fund themselves beyond 2012.
The latest news on Greece underscores why a restructuring must occur. The European Commission, the European Central Bank and the IMF issued a sobering nine page report on the outlook for Greece. According to Der Spiegel, the report states that it is unlikely that Greece will be able to return to borrowing money on the capital markets in 2012 as previously foreseen -- meaning European taxpayers will probably have to prop up Greece with billions in payments for much longer than was originally planned.
"Although there is some evidence that the rebalancing of the economy is ongoing and the quarter of deepest contraction (has) already been passed, a further contraction in real GDP is still expected in the second half of 2011." The real GDP growth rate for 2011 is now protected to be minus 3.8 percent, the authors conclude, adding that positive growth rates are not expected before 2012. Even then, they will only be "moderate." Remember, the IMF has statutes that stipulate they can only release money to a country if it is certain that the state will be able to meet its payment obligations for the next 12 months. Given Greece's outlook for growth, they will unlikely be able to generate revenues and therefore unable to meet this criteria.
In short, a restructuring of Greek debt is paramount to solving the crisis as the country will be unable to support its current and future debt loads. If Greece was not part of the European Union and the Euro, it would've likely already restructured its debt and devalued its currency. In this case, private owners of the debt would see a potential loss conservatively between 30-50% of the principal.
The problem is that private investors are not the only significant owners of Greek debt. The European Central Bank is estimated to own E40 billion and has stated emphatically that it doesn't want a restructuring or default. This past week, ECB President Jean-Claude Trichet stated, "We would say it's an enormous mistake to embark on a decision that would lead to a credit event (for Greece)." Also, private investors are dumping the debt, reducing their exposure and putting more of the debt back on to the public sector. (As an example, Germany's Die Welt paper says German insurance companies have dumped nearly half their holdings and German banks have dumped 40 %.)
What does this all mean? Greece's debt burden is unsustainable, additional debt is unlikely to solve the issue and a restructuring will cause the ECB to take losses on the Greek debt they hold despite their vocal opposition to it. The added difficulty with Greece is that a restructuring for them will likely trigger a restructuring for Ireland and Portugal as well. Therefore, the deal will need to involve many interested parties and necessitate buy in from them. This will not be a simple task and there will likely need to a strict deadline to be met to create a crisis-like condition to mandate a solution.
Given this, what form could a restructuring look like? Throughout the last 30 years, there have been numerous successful sovereign restructurings from Mexico in 1982 to Argentina in 1992 Uruguay in 2003. All were innovative and all required assistance from both the private and public sectors including regulators. I believe a Greek solution will require a hybrid of these to solve the multitude of problems.
First, there will need to be a backer of new debt to be issued to replace old Greek debt coming due. Like Mexico in the 1980s, there will likely be a choice offered to current debt holders to swap into new debt. The first choice could be a 30-50% forgiveness of loans in exchange for the remaining 40-60% new floating rate debt collateralized by EU bonds. The second choice could be a swap for bonds backed by EU bonds that maintain face value, but at interest rates significantly below market levels. For either choice, there must be a back stop for this to work or it must be the European Union.
Next, the credit rating agencies must be consulted and bargained with to ensure they not only view this positively, but also agree that this won't trigger a credit event. This will mean that credit default swaps will not have their clauses triggered and the domino effect onto other nations will not occur. How each service views the ultimate deal will likely shape the structure of the deals. Clearly, the language is key and "voluntary" appears to be critical for the process to avoid a technical default. However, governments can put tremendous pressure on these firms to participate in their approval.
Also, key regulators within the European Union and the United States will need to give tacit approval that no additional capital set aside will be required should banks go along with the deal. This was a critical component for the 1982 Mexican restructuring when Federal Reserve Chairman Paul Volcker participated. Given the recent mandated increases in global regulatory capital from Basle III, this part will be needed or banks will not agree to participate.
Finally, the European Central Bank will likely have to be made whole on their holdings of Greek, Irish and Portuguese debt. While the ECB is seen to hold E40 billion of Greek debt, its total holdings of government bonds of peripheral euro-zone countries is more than E75 billion.
To summarize, it is clear from the recent report from the IMF/ECB/EC that Greece's debt burden is unsustainable and therefore they will not be able to return to the global capital markets any time soon to refund their debt. This mandates that a restructuring must take place to solve the problem. Investors will most likely be given a choice of bonds to swap their current holdings with potentially one being partial forgiveness with a market floating rate and the other being a fixed rate, but greatly reduced from current market. Both bond choices will need to be collateralized from the European Union or an entity that has the backing of the European Union. Finally, the European Central Bank must be made whole on the losses stemming from the restructuring.
Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.