“I would not say that Mexico is going to be a cookie cutter for others.”
– William Rhodes, Citibank 1989
These were the words of the chairman of Mexico’s Bank Advisory Committee in 1989, just after the country and its commercial banks creditors agreed to the first, and ultimately, prototype Brady Plan Debt Restructuring. Twenty-one years later, the now EU struggles with how to deal with member countries that have borrowed too much and will, ultimately, be forced to restructure their sovereign debt.
The quicker EU leaders – and hopefully in private – recognize the inevitable, the better, as a disorderly default will be much more damaging to both Europe and the global economy. The Economist’s, Free Exchange blog, makes a pretty good case that EU leaders are following the same path and inadvertently using Argentina as a “cookie-cutter” in dealing with their own debit crisis,
For now the European Central Bank has held the euro zone together by purchasing members’ bonds and providing liquidity to beleaguered banks. Although such stopgap solutions, like case-by-case bail-outs, are the path of least political resistance, the effort to avoid defaults at all costs could prove calamitous.
Argentina’s recent default is illustrative. As in Europe today, Argentine politicians ruled out restructuring debts that looked unmanageable. Domingo Cavallo, Argentina’s respected finance minister, even took to the pages of the Financial Times to call the idea “ludicrous” and promise that “Argentina will not be lured by the call of the sirens”. And so throughout 2001 the country attempted increasingly desperate manoeuvres—two IMF loans, a short-for-long securities “megaswap” and finally zero-deficit budgeting—to stave off default…
Of course, Argentina’s default was only inevitable in hindsight, and euro zone leaders cannot be so certain of their fate. Nonetheless, it’s important for the EU to seriously engage with the potential need for planned, systematic debt restructuring because the alternative—a slow motion train wreck ending in disorderly default—would be far more dangerous. When it comes to debt restructuring, MacBeth’s advice remains true: “if it were done when ‘tis done, then ‘twere well / it were done quickly.”
Unfortunately, the logic of politics incentivises default denial. Even if delays increase the risk of a disorderly default, European leaders will struggle to accept the known, certain harms of debt restructuring while there is still hope, however remote, of avoiding it. Necessary or not, the decision to default is likely to be career-ending, which shortens politicians’ time horizons and encourages risky “double or nothing” gambles (as with Britain’s Black Wednesday devaluation).
During a crisis and heightened market volatility, it’s extremely difficult, as EU leaders are now learning, to create a mechanism to address the debt overhang. The Economist writes,
In theory, creating a structural mechanism to wind down sovereign debts in an orderly way would help alleviate this problem. But it seems impossible to implement such a plan in the middle of a crisis—any hint of bondholder haircuts risks setting off market anxieties and triggering a disorderly default, as shown by the reaction to Angela Merkel’s suggestion for incorporating debt restructuring in future bail-outs.
Finally,
A euro zone default, disorderly or not, will reverberate around the world. The shattering of Europe’s illusion of fiscal responsibility would cause a re-evaluation of other developed countries’ debt burdens—no longer will rich world sovereign debts be treated as “risk-free”. In fact, such a re-assessment may already be underway: over the last month, 10-year Treasury yields have risen by about a quarter to 3.3%, British yields are above 3.5%, and even German yields hover around 3%.
One thing for certain is 2011 is going to be one interesting year.
Related Articles:
Europe’s Inevitable Haircut – Barry Eichengreen
Living to disorderly default another day – Economist
The eurozone is in bad need of an undertaker – Telegraph
