Options on default

Tom O'Connor12/05/2011

Tom O'Connor: Doomsday scenarios have been painted recently by Prof. Morgan Kelly and others concerning the need to abandon to EU/IMF deal on the one hand or totally repudiate the debt on the other. Kelly has suggested we abandon the bailout and balance the exchequer books immediately. Balancing the books immediately is not an option however.

The newly elected Fine Gael TD Paschal Donohoe has warned against abandoning the bailout, predicting huge cuts in social welfare. The Central Bank Governor, Paddy Honohan is defending the bailout and fighting to save his reputation. There is a huge amount of kneejerk-ism around and people taking sides. I attempt in this post to stand back and examine evidence which might inform the way forward.
Let’s start with the most radical scenario, Argentina: In 2002, it had developed a triple financial crisis in terms of its unmanageable fiscal deficit, banks which were broke and ultimately a government external debt crisis as a result. To a large extent, this is where Ireland is right now. In January 2002, Argentina essentially abruptly defaulted on $81.8 billion of its external debt without consultation with creditors.

This led to a run on the banks. It wiped out the savings of citizens. It dramatically increased the cost of borrowing by the government and deflated the size of the economy by 25% in one year from 2001 to 2002. The collapse of the currency greatly indebted the country also, as much of it was denominated in dollars.

For many years afterwards, Argentinean credit has been more costly in its bond spreads. Bond debt has been more costly there and in Ecuador, far higher than in other countries which had restructured their debt with creditors in advance, such as Ukraine (1998) and Uruguay (2003).

Argentina and Ecuador also imposed large haircuts on the debt on which it defaulted, far higher than that of countries which had negotiated in advance. Ukraine and Uruguay imposed lower haircuts and in the years that followed, their bond spreads were lower. This means that they could subsequently borrow more cheaply as a reflection of the greater level of international trust in these countries.

Nonetheless all four countries did eventually formally agree repayment terms with the IMF, either pre-default or post-default. This happened under the IMF’s Sovereign Debt Restructuring Mechanism (SDRM). According to Professor Nouriel Roublini, at this point the European Union should examine this mechanism as the way forward for debt restructuring, and not be wasting its time looking for new legal mechanisms.

Working on his evidence as well as that contained in work by De Paoli (2006), Gelos (2004) and others, there is strong evidence to suggest that the preferred option is a partial and negotiated restructuring of debt in advance of a default. The term ‘restructuring’ sounds more positive and is more advantageous.

Nonetheless, a negotiated ‘restructuring’ is still a default according to the eminent work of Reinhart and Rogoff (2009). The benefits of lower bond spreads in the years following a ‘restructuring’ or ‘exchange offer’ (Roubini) of a restructured debt are augmented by a significantly less negative impact on growth in the years ahead on the ability raise finance internationally. This negotiated mechanism (as in the SDRM) reduces ‘deadweight costs’ also such as costly legal proceedings. It is infinitely better than allowing a country to stumble towards default to the destruction of its economy. This resembles death by a thousand cuts.
Taking this eminent advice on board, I would suggest that the EU/IMF deal needs to rescinded and replaced with Ireland cutting a deal on external debt, including sovereign debt and the debts of the Irish Banks.

The current bailout offers bad terms for Ireland. The prospect of repaying 70 billion worth of bank debt without any deal on writing down the bonds involved, at a rate of interest of 5.8% cannot be done, particularly as it will have to be paid in conjunction with sovereign exchequer debt. The repayment of 8 billion a year in interest is off the scale.

On the basis of the evidence from international experience, the bailout needs to be replaced by an IMF led Sovereign Debt Restructuring Mechanism (SDRM). Many Irish economists have pointed to the fact that under the current bailout, Ireland will become insolvent by 2014. The country cannot sit back and wait for this to happen. Instead, it needs to offer, along with other euro zone countries in danger of default, what Roubini terms a ‘pre-emptive, pre-default exchange rate offer’.

Without a default, national debt will be 225 billion in 2014 and our GDP according to the Dept of Finance will be only 184, a debt/GDP ratio of 122%. This figure 225 does not include NAMA. This 184 debt would include 70 billion of bank debt if we include the recapitalisations from 2008 till then. At that point, the sustained debt would be over twice the international solvency rule of thumb whereby a country needs to keep its debt below 60% of GDP.

The Roubini Pre-Default Exchange Offer under existing IMF rules should be done in the same was as was done in Pakistan, Uruguay or Ukraine and in many other countries in recent years. The EU/IMF deal should be cast aside.

This would be a partial default. It needs to be planned with creditors. A haircut of at least 50% on the bank debt of 70 billion needs to be agreed right away. Haircuts of this magnitude have been proposed by Rogoff and Roubini.

Exchequer debt needs to be extended well beyond the 7.5 years of average maturity which exists under the EU/IMF deal. A significant cut in the interest rate on sovereign external debt will also be necessary alongside a possible haircut also. The 160 billion owed to the ECB by Irish banks will also need to be restructured. These are some of the areas of ‘offer’ that the Irish government needs to make to its creditors.

Another international model which might inform the default is that of South East Asia in the late 1990s. After receiving IMF funds, they opted out of their quasi-fixed exchange rate with the dollar and devalued significantly. They recovered economically far more quickly than Hong Kong which stuck with the dollar. If Ireland sticks with the euro under a default, its recovery will take longer, as happened in Hong Kong. By contrast, the devaluation of the currencies in Thailand, Indonesia and South Korea greatly added stimulation to their economic recovery.

This scenario would help greatly in avoiding severe cutbacks in wages, social welfare payments and public spending. The scale of future GNP increases is also key to preventing punitive measures been implemented by the Irish government on its population. A significant economic stimulus is needed in this regard.
Despite the warnings of some commentators however, the published evidence does not necessarily support the inevitability that pay rates in the public sector and social welfare payments will automatically be dramatically cut in the event of a default.

If a default is ‘offered’ pre-emptively by a country in negotiation with creditors and particularly under the IMF (SDRM), recovery may happen within three years according to the in-depth research by Reinhart and Rogoff of Harvard. With access to capital markets within months and growth restored quickly, penal cuts to public pay and welfare are not in any way an inevitable and may in fact be prevented.
After a default, countries are not ‘blacked’ for finance for long periods and usually can access market finance within four months in many cases, according to a study by Gelos (2004). An exhaustive World Bank study by Zettelmeyer and Sturzenegger (2007) also echoes the view that default is far from a doomsday scenario. Many countries recovered quickly despite the negative effects on economic growth and the increased cost of borrowing. Argentina and Russia are cases in point.

In addition, it may well be the case that the blanket austerity being demanded by the EU and IMF under the bailout plan would be a lot worse and more punitive on those not responsible for the problem, than would a structured default where Ireland exerts more control on its own affairs.
It is obvious that Greece Will negotiate a default very soon. It seems increasingly likely that the EU cannot hold back the tide of default. The Portuguese bailout may never fully even get off the blocks and it certainly does not look sustainable.

The Irish government needs to stop burying its head in the sand and posturing about a possible lowering of the interest rate in the bailout. This bailout will not work. Modelling from other countries demonstrates that a negotiated default needs to happen as soon as possible. This will give the economy a better chance of bouncing back quickly, a lesson that has been learned from Japan’s stubbornness in this regard heretofore.

A Debt Audit Commission was set up in Ecuador in 2007. Some unions, academics and civil society groups have been calling for one to be set up in Ireland. This will determine the fairest course of action on defaulting. This could inform the way forward.
this piece originally appeared in the Irish Examiner

Posted in: EconomicsEconomicsFiscal policy

Tagged with: defaultgovernment bondsdebt

Dr Tom O'Connor     @justeconomics

O'Connor, Tom

Tom O’Connor is a lecturer in economics, public policy and health/social care at Cork Institute of Technology.


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