Cross-posted from Credit Writedowns
Yesterday, I had the pleasure of talking on CNBC along with Marc Chandler of Brown Brothers Harriman about the European sovereign debt crisis. I also wrote a piece in the New York Times about the same issue, concentrated on Greece. While Marc and I differ somewhat in tone, we are both clear that eventually a restructuring of principal will happen.
Here’s the background to what we said:
- Greece needs a strategic plan. At a minimum, a soft restructuring – that is to say, a voluntary reduction of interest rates and an extension of maturities – will happen sooner than later under the EFSF facility. While this is necessary, it will certainly not be enough. Eventually, principal reduction will occur.
- Bank capital must be protected from immediate losses. Principal reduction has to be done with timing and in a way that considers the stress to Greek and foreign bank balance sheets. The problem with an involuntary default is that it would trigger immediate losses and panic. Europe’s banks are still undercapitalised; so such a default must be avoided at all costs.
- It is unclear whether the move to principal reduction will be messy. An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
- Neither Marc nor I mentioned a euro zone break-up. My view is still that some combination of monetisation and a voluntary default, hard restructuring package is the most likely scenario for Europe. When I handicapped scenarios after the Irish stress tests in late March, I felt this way. I still do now. This means that when you look at the three options for the euro zone, monetisation, default, or break-up, I see break-up as by far the least likely. Again, a hard restructuring/soft default is much more likely.
- Credit default swaps triggers can be avoided. My view is that a restructuring that involves maturity extension, interest rate and principal reduction via an exchange of bonds or a roll off of maturing issues does not necessarily have to involve a technical default that triggers credit default swap payments. If a strategic plan is properly conceived via bond exchanges, investors will lose money but actual default can be avoided. Obviously, a reduction of principal is still a loss of money for investors. But, it is key that this loss take place with as little unwanted negative consequences for other euro zone debtors and the banking system.
I wrote a follow on piece in the New York Times, detailing how to prevent the ‘somewhat messy’ situation we have now from becoming uncontrollable. Here are what I consider the hallmarks of a good plan:
- Growth is key. Austerity decreases output, so immediate principal reductions are necessary to keep the debt burden manageable
- Incentives must be built in for both investors and debtors to share in the upside of growth and recovery. The stick does not work without the carrot.
- We want to see Greece with market access at reasonable rates as soon as possible. Therefore, any plan must offer credit enhancement because Greece has lost credibility with the market.
- The banking system must be protected. See my second bullet point in the first section about European bank capitalisation. And note that investors like Felix Zulauf feel that Europe’s banks are winning the battle with regulators to allow them to remain undercapitalised.
Clearly, all of this contingency planning should be done in private right now. In the meantime, the present arrangement, or even a soft restructuring would aid Greece until a permanent solution is found like the one proposed by Evans and Allen.
Please read the full NYT piece on the Greek crisis here along with the opinions of other commentators.
CNBC Video below.