Why Europe Should Accept the Possibility of Default

The European Central Bank decides on interest rates later Thursday, and while markets are looking for clues on what will happen next, more and more voices raise the possibility of debt restructuring in the euro zone.

EU building flags brussels
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EU building flags brussels

European policymakers need to learn from previous debt crises and accept that a swift restructuring of Greek debt may be preferable to a protracted response, according to Alessandro Leipold, chief economist of the Lisbon Council and former acting director of the International Monetary Fund’s European department.

Leipold studied previous debt crises, including those in Uruguay, Pakistan, and Ukraine and came to five recommendations – removing the EU’s "arbitrary and non-credible deadline" that precludes restructuring until 2013; speeding up bank recapitalization and financial sector stability reforms; reducing the role of politics in crisis negotiations; using pre-emptive bond exchange offers; and reducing the emphasis on collective action clauses.

The international financial institutions have learned a lot about crisis management, and their experiences need to be heard in any attempt to resolve the mounting concerns over the ability of Greece to manage its debt mountain and avoid a sovereign default, Leipold told CNBC.com.

“The IMF before the Latin American crises would not lend to a country that was in arrears to private creditors,” he said.

“I am trying to get the Europeans to be less parochial,” he said. “Obviously Greece is not Pakistan or Uruguay, but this has worked in the past… There are ways of doing it that can minimize the cost and the pain.”

“There is a tendency in Europe not to look at international experiences or the IMF, which is seen as a Washington-based organization,” he added.

Greek Troubles

Publicly, the Greek government and the European Commission have rejected the possibility of restructuring Greece’s debt – which ran to more than 140 percent of gross domestic product in 2010 – until after 2013.

However, with finance minister George Papaconstantinou floating a request for a further extension on the repayments on last year’s 110 billion ($160 billion) IMF/EU bailout package, many in the market believe that some form of haircut or restructuring is inevitable.

If a restructuring is indeed needed, experience shows that delays will only rack up the cost of a rescue, as public institutions “throw good money after bad” and ultimately mean that private creditors will need to take an even bigger haircut to achieve the same reduction in indebtedness, the paper says.

Deutsche Bank research estimates that the cost to the European banking sector of a 50 percent haircut on Greek debt would be around 160 billion.

Policymakers need to understand the true stability of the banking sector in the event of a sovereign default, Leipold said.

The bank stress tests instigated by the EU in 2010 - and which are repeated this summer with tougher conditions - do not consider sovereign default scenarios, which undermined their credibility, according to Leipold.

These stress tests need to become more rigorous and must be accompanied by pressure from policymakers to speed up recapitalization, he said.

He is short on sympathy for banks, adding: “the fact that Greece was going down the tube was known since December 2009… if the banks haven’t strengthened their capital or reduced their exposure then… what can I say?”

Cut Politicians' Role

Leipold’s third recommendation – reducing the role of politics – is a difficult and distant prospect, given the unique context of the EU’s multilateral politics and the many national stakes in the game.

“I don’t think that ever before the creditors have played such a prominent role in the decisions regarding a debtor,” he said.

“The political theatre that surrounds European Council meetings, where the ministers are expected to come out and play to domestic audiences and say they have defended their country’s interests… raises the burden and gives conflicted messages to the market. It doesn’t help crisis resolution,” Leipold added.

The problem is encapsulated by the negotiations in Finland over the formation of a coalition government. The euro- skeptical True Finns emerged as the third-largest party in the country’s April 17 election and have put opposition to euro zone bailouts high on their agenda as they discuss joining any future government.

While announcing to the market that restructuring is on the table could precipitate such an event, private discussions within the European Commission, followed by a single, unified voice – perhaps European Council president Herman van Rompuy himself – would be preferable to the current system of rumors and politicking, according to Leipold.

“Communications is as much a tool as anything else in crisis management,” he explained. “Right now a lot of market jitters come out of the market not knowing who to believe.”

Leipold suggested that pre-emptively using bond exchange offers worked well in debt restructuring in Pakistan, Ukraine, Uruguay and the Dominican Republic, although he acknowledges that the increasingly widespread belief in the market that Greece will default means that the moment for this may have passed.

Finally, he adds, the collective action and aggregation clauses that some in Europe have mooted as a possible solution are far from a panacea which “no doubt help at the margin, but they have not shown themselves to be decisive in debt restructuring,” he wrote.