Wednesday, October 24, 2012

Bailing Out Europe Again and Again

While it is hard to imagine, Europe's debt crisis is nearly entering its third year.  So far, Europe has managed to contain most of the damage to its own territory; the United States, Canada and the Far East are still showing economic growth levels that are modest but still positive and the crisis in the bond market has not spread beyond the Eurozone.  Unfortunately, everything is still not "well"; Greece is walking a debt tightrope, Portugal and Ireland are wards of the EU and the IMF and Spain and Italy hover near the doors of the casualty ward with bond yields that look like this, suggesting that all is not well:

A paper by Lee C. Buchheit and G. Mitu Gulati entitled "The Eurozone Debt Crisis - The Options Now" give us insight regarding what tactics the Eurozone can employ to assure the world that all is now well.

Looking back at the Latin American debt crisis of the 1980s and 1990s, the IMF enthusiastically and predictably prescribed the same formula for debt transgressors:

1.) Raise taxes
2.) Cut expenditures
3.) Restructure debt

This "program" forced debt holders and lenders to extend their loans or accept the consequences of a haircut to both principal and interest.

In the case of Greece, the "program" unfolded in a far different way.  Initially, Greece basically used taxpayers' money to repay existing lenders at par because there was a great fear of contagion as the crisis spread to Portugal, Ireland, Italy and Spain.  On top of that, since most of Greece's debt was held by French and German banks, a restructuring of the debt could have had severe negative consequences for the balance sheets of these supposedly "strong" banks.

By the summer of 2011, it became apparent to governments, the IMF and central banks that they were becoming the lender of last resort to Greece.  At that point, the "official sector" began to insist that the remaining private sector bondholders voluntarily agree to a restructuring of their claims against Greece.  The end result of this was a write-off of 53.5 percent of the nominal amount of the debt.  This process erased roughly €100 billion from Greece's outstanding debt held by the private sector.

While the Greek debt crisis is over for the present, other nations find themselves in the crosshairs.  The IMF and EU argue that nations like Spain and Italy have taken budgetary steps to avoid crises and that all that is required is time to let fiscal responsibility work its way through the system.  Once the bond market notices that the newfound budgetary constraints are permanent, the markets will reward the governments with lower interest rates on their debt.

In the meantime, how does the world deal with nations like Spain and Italy, potentially next in line for the "Greek treatment"?  Here are five steps that could be taken:

1.) Jolly the Market: Politicians from the debtor countries cajole the markets that the newfound voluntary fiscal restraint that these nations have adopted are permanent and irreversible and that eventually, everything will be okay and the markets will reward their good behaviour with lower interest rates.

2.) Massage the Yields: If the first option fails and yields do not fall voluntarily, the EU, the ECB and the IMF (the official sector) will take action in the bond market to force yields down by purchasing additional volumes of debt so that the debtor nations can borrow at reasonable rates.  As well, the official sector could offer a form of credit insurance, lending their "AAA" credit rating to that of the debtor nation and pushing yields down.  While these proposals look good on paper, the ECB's purchases of bonds from Greece, Ireland and Portugal at the beginning of the crisis did little to fix the problem over the long haul.

3.) Full Bailout: If the measures listed above fail, the debtor nation will require a full bailout from the official sector will be forced to bailout the full amount of the debt that is maturing during the period of the bailout program as well as covering the amount of budget deficits during that time.  This avoids the dreaded "default".  Unfortunately, this clearly did not work during the initial part of the Greek bailout.

4.) Reprofiling: If the official sector decides not to bailout existing creditors at par as they did in stage one of the Greek crisis, restructuring of the debt is required.  This can be done by moving the maturity of the debt to some point in the future by a fixed number of years.  This avoids a painful debt haircut and the interest owing on the debt remains at the coupon rate.  This has several advantages:

    no loss of principal.
    no need to fund maturing debt.
    the private sector bears the weight of the restructuring.
    interest rates remain relatively low.

5.) Full Restructuring: This is where Greece found itself in mid-2012.

Where does the European situation stand today?  Spain, with its debt of over €860 billion already finds itself at Step 2 - Massaging the Yields.  In September, the ECB began a program it called the Outright Monetary Transactions program (OMT) which will see the ECB purchase one to three year bonds of Eurozone countries in unlimited amounts (crank up those "printing presses") to push prices up and yields down.  This was also seen as a mechanism to reduce the interest rate spreads between the northern Eurozone nations and their less fiscally robust southern neighbours.  Unfortunately, as shown on this chart, the "supply of European debt is huge, particularly when Italy is included:

There are several significant risks to the OMT program:

1.) Potential losses to the ECB, should they be forced to declare the mark-to-market on their risky bond portfolio, could be staggering.  

2.) Investors will only buy the bonds at the lower yields created by the ECB purchases if they are assured that the ECB is standing behind them.

3.) Debt issuers may try to concentrate their bond issues at the short end of the curve (the one to three year period) where the OMT program is pushing yields down.  As the authors state, "Why borrow for ten years at 9% when one can borrow for two years at 3%?".  This artificial distortion in the yield curve could produce a very, very dire situation if the debt transgressing nations choose to issue only short-term debt.

4.) Austerity fatigue could erupt in the nations that are beneficiaries of the OMT program.  Since public resentment of austerity measures tends to rise when organizations like the IMF, ECB and others are involved in bailouts, the ECB could be backing itself into a corner when austerity fails.

As we can see from this paper, Europe as a whole has backed itself into a corner where the only options are extremely unpalatable over the long-term.  The only thing saving the world's economy right now is the pass that the United States and Japan are being given on their $27 trillion worth of sovereign debt.  Without that, the world would be awash in a sea of worth-less government-issued paper.

1 comment:

  1. The bailouts are a Ponzi scheme and higher taxes and more austerity are not the answer. The answer in the long term is ECONOMIC GROWTH. In the short term, the Eurozone must let the PIIGS leave. The risk of Eurozone Depression is extremely great. It is not just a case of mark to market of the bad bonds held by the ECB, it is much worse as outlined below: