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Will Greece Resolution Spark a Bigger Crisis?

Thursday, 8 Mar 2012 | 2:58 PM ET
The Parthenon in Greece
Scott E. Barbour | Getty Images
The Parthenon in Greece

Markets around the world were buoyed on hopes that Greece’s long and winding journey to debt restructuring may at last be its final port of call.

But some are warning that this may actually be the beginning of a new and more dangerous crisis.

The private sector is being asked to write off more than 70 percent of the face value of their Greek government bonds in return for new debt. This will help Greece meet its debt obligations and enable it to tap into bailout funds from the EU and IMF.

It seems likely that other nations burdened by heavy debt loads and high interest rates may seek to follow Greece’s path to debt relief. If Greece doesn’t have to pay what it owes, they might argue, why should we? Call it Haircut Contagion.

European officials insist that Greece is a one-time deal, not meant to set a precedent for other nations. But it is easy to see that minority parties in debt-burdened European nations could find a demand for relief an attractive platform. Imposing a “tax” on bondholders rather asking citizens to pay higher taxes while public services are cut might prove popular with voters.

Demands for debt relief could take many forms. Greece has been able to encourage bond holders to participate in the debt swap by enacting laws that incorporated “collective action clauses” into the 86 percent of bonds governed by Greek law. These clauses allow super-majorities of bond holders to force hold-outs to participate in swaps. Other countries in the euro zone could replicate this strategy.

“Effectively, this is a large gift from the Greeks to the parts of the euro zone that face debt crises. By conducting its debt exchange in the way it did, Greece has in effect resurrected the plausibility of purely voluntary debt-reduction operations in Europe,” Moody’s has explained.

Such demands would put new strains on the global financial system. While Europe’s banks and insurance companies can withstand losses on Greek debt, a series of similar haircuts might destabilize the system and render some institutions insolvent.

Warren Mosler, a trader based in the Virgin Islands who is credited with creating the euro-swap futures contract, fears that all it would take to set off a panic would be serious political discussion of widespread haircuts.

“The idea of Greek default transformed from being a Greek punishment to a gift, with the pending question: ‘If Greece doesn’t have to pay, why do I?’ — threatening a far more disruptive outcome that is yet to be fully discounted,” Mosler writes on his website, Mosler Economics. “That is, should Greek bonds be formally discounted, the consequences of merely the political discussion of that question will be all it takes to trigger a financial crisis rivaling anything yet seen.”

He has spelled out exactly what he thinks would happen in a Haircut Contagion crisis.

“Possible immediate consequences of that discussion include a sharp spike in gold, silver, and other commodities in a flight from currency, falling equity and debt valuations, a banking crisis, and a tightening of ‘financial conditions’ in general from portfolio shifting, even as it’s fundamentally highly deflationary. And while it probably won’t last all that long, it will be long enough to seriously shake things up,” Mosler writes.

A recent paper cited by Reuters took a much more sanguine approach to the likelihood of Haircut Contagion. The ratings agency figures that countries may attempt to receive modest debt relief in exchange for giving up their rights to unilaterally change the terms of their debt. They could do this, for example, by restructuring bonds governed by domestic law into foreign law bonds, mostly likely governed by English law.

“Holders of local-law governed bonds in other euro zone countries that are perceived to be at risk might want to make a trade for English-law governed bonds,” Jeromin Zettelmeyer, deputy chief economist at the European Bank for Reconstruction and Development, and Duke University Professor Mitu Gulati, wrote in the paper. “Depending on how much these bondholders would be willing to pay to make this trade, it could serve the interest of the country as well to make it.”

Of course, countries that agreed to make this swap would be sacrificing a lot of their future flexibility. Some might find it too high a price to pay. In a sense, converting their debt to foreign jurisdiction bonds would be like doubling-down on the structural problems with the euro zone. The countries that did this would sacrifice sovereignty over their debt to achieve lower interest rates, much like they sacrificed monetary sovereignty for the currency union.

And it’s not clear that this would be all that attractive to bondholders, either. After all, a country that cannot or will not pay its debt cannot be forced to, just because the bonds are subject to foreign law.

The hope of European leaders was that preventing a disorderly default in Greece would avoid a domino effect of sovereign debt defaults. The danger, however, is that debt relief for Greece could spark a new and unexpected Haircut Contagion crisis.

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