Here is another thought on the euro debt crisis. We might just as well go all the way in trying to solve the euro crisis and give all suspect sovereign debt situations a 'haircut.'
Why? Well, there is a rather simple reason for it.
By first discussing the possibility of a 'haircut' on Greek debt and then implementing one as policy, the investor illusion that euro sovereign debt was one of the safest investments around has been shattered. Euro member countries cannot issue their own currency and hence, unlike countries that can, their debt has no implicit central bank guarantee that it will always be paid back. Euro member countries de-facto issue debt in a currency they cannot control, which makes their debt more like those of emerging markets.
Emerging markets succumb to (occasional) defaults because they borrow in currencies which they cannot print. Hence, markets usually have a lot less tolerance for their public finances (crisis often happens at deficit and debt levels considerably lower than are common in the euro area today).
But the Greek 'haircut' has basically put the debt of Greece, but also of Ireland, Portugal, Italy, Spain (the 'PIIGS' with Belgium and possibly even France to follow), on much higher interest rates. Italy and Spain pay roughly 6% on their 10 year debt, three times as much as Britain and the US (which pay only 2%).
The crucial difference is not the state of their public finances (which are comparable and in some respects actually better) but the fact that Britain and the US can issue their own currency, and so have a lender of last resort (their central banks) that makes default very improbable.
Higher financing cost can easily produce a vicious cycle, the increased financial burden worsens the deficit which leads to more scared investors and even higher interest rates (apart from making more austerity necessary, which reduces growth and makes stabilizing the debt/GDP ratio even more difficult).
This is already happening in countries like Italy and Spain, which are much more likely to be solvent if they had to pay similar interest rates like Britain or the US. With the EFSF not yet enabled to buy bonds on the secondary market and other euro solutions not on the horizon, it's only the ECB bond buying that keeps Italian and Spanish debt from spiraling out of control.
Cat back in the bag?
Having let the cat of haircuts or defaults out of the bag, can it be put back in? We doubt it. Say the euro area politicians indeed embark on the solution which had markets rallying after the IMF/World Bank meeting end of September and create a EFSF on steroids (say 2 trillion euros). Would that be the proverbial 'bazooka' that will get interest rates on Italian debt back anywhere to British and American rates?
Optimists argue that since such fund could indeed buy up the whole of Italian outstanding debt, it's such a credible threat to the markets that it wouldn't have to be needed. No speculator is going to take on an adversary this big (and supposedly determined). Against that reading, there is another, provided by Simon Johnson (former chief economist of the IMF) and Peter Boone:
If the big government money shows up, and this pushes down yields on Italian government debt, what will the private-sector holders of that debt do? Some of them will sell, taking advantage of what they worry may be only a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise).
So the European/International Monetary Fund bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps that of Greece and Ireland). If the credit used from this fund, with its central bank backing, reaches — let’s say — 1 trillion euros, how will the Germans feel about the situation?
And this doesn't even touch additional problems like the possible effect of expanding the EFSF on the credit ratings of France (or even Germany itself), and the additional recourse to capital markets as a result of existing deficits in these countries.
It's difficult to say in advance what will happen, but now that the cat is well and truly out of the bag, it's difficult to foresee a scenario in which interest rates will go back to pre-haircut times.
So perhaps something else should be thought about.
Haircut for all?
What might that be? Now that the haircut for Greece shattered the illusion that public euro debt is safe, the cost for additional haircuts in terms of lost market confidence is much lower. It's basically like losing one's virginity. One can lose it once, but not twice.
The immediate and obvious candidate for a haircut is Greece itself, that is, to give it a much bigger haircut, and it seems this indeed is what's on the cards.
The fact that the damage to Spanish and Italian interest rates has been mostly done already (let alone the interest rates on Irish and Portuguese debt), one could extend the same logic to these countries. Why not get it over with and give all the PIIGS a haircut?
Haircuts could provide a rather large one-off opportunity to put public sector financing on sounder footing. In such scenario, if countries could take necessary steps to reduce public deficits to get primary budget surpluses, the ensuing negative effects on growth, and hence public finances themselves could be substantially compensated by the one-off debt reduction.
This might provide the best chance for putting euro sovereign debt on a more sustainable footing. Austerity alone isn't likely to solve the crisis (note how deficits in Greece and Ireland are hardly budging), especially if all countries are at it at the same time, creating negative spill-over effects on economic growth.
But combined with a one-off debt restructuring, the chances increase substantially, especially if done in a clever way that most reduce immediate financing needs by extending maturities.
Haircuts are of course anathema to the regions already stressed out banks. There are two problems here:
- Bank liquidity
- Bank solvency
Bank liquidity is a problem that derives from banks being locked out of the money market because other banks don't want to lend to them. But this can be taken care off by the ECB, which already has embarked upon what is basically limitless provision of liquidity.
Bank solvency is not the territory for central banks (although even here there have been exceptions, mostly in the US) so lets assume the ECB stays out of this. How much capital would banks need?
An alternative is to re-run the tests with the same data, while forcing the banks to mark all sovereign bonds to current market prices. In that scenario, 18 banks would fail, with a capital hole of 40 billion euros, according to Breakingviews’ stress test calculator. But that would not be enough to restore confidence. The International Monetary Fund puts the capital shortfall of European banks at between 100 billion and 200 billion euros. Some analysts have come up with even higher numbers.
These are much smaller figures than the 2 trillion or so that is needed for any credible beefing up of the EFSF trying to ring-fence sovereign debt. Even putting the haircut of all PIIGS at 100%, and raising the tier-one capital requirement to 7% (5% was used in the European stress-test), the capital shortfall that comes out of the nifty little stress-test calculator by ThomsonReuters (feel free to play around with it) is 568.2 billion euro.
Clearly other market parties like non-euro banks, hedge funds, bond funds and institutional investors would take a hit too.
Financing could come from capital markets, the IMF and national governments, although Sarkozy prefers to use the EFSF because of the risk that France might lose its triple A rating.
The difference with an EFSF on steroids buying bonds type of solution versus a one-off haircut for all PIIGS is that the EFSF would buy bonds from all holders. It is simply a reflection of the fact that lot's of PIIGS' debt is held by non-bank institutions and outside of the euro area.
A bank recapitalization effort would be concentrated on euro-area banks alone (although one contention is whether EU countries outside the euro, like the UK, should join these efforts).
A natural an viable objection to this plan is whether the countries after having sent their bondholders to the hairdresser (or perhaps the cleaners) can go back to the markets to borrow more. There are a number of points to consider.
The chances of that would be improved if the haircut is accompanied by some serious budget cutting. If this still doesn't help to re-establish a modicum of market confidence, they could get refinanced by the EFSF but with debt burdens reduced.
The 'haircut' could be designed in such a way as to minimize the near-time financing needs, by extending maturities, creating something of a grace period, there is a window of opportunity to get public finances on a sustainable path and re-establish market confidence.
But perhaps the real issue is this; how long would it take for countries like Italy and Spain to lose access to the markets if the ECB stops buying its bonds? Any alternative has risks and awkward choices involved.
Even if the EFSF is greatly expanded or leveraged, the same problems will manifest themselves. Markets have woken up to the possibility of default and are repricing many euro bonds, triggering vicious cycles one way or another.
Either the ECB or the EFSF keep on buying up bonds until austerity has finally put public finances on a more sustainable path, or we have one-off haircuts which would help getting on such path earlier (or at least the chance of that).
The markets are already very much pricing in such haircuts anyway, especially after they became official policy in the second Greek bail-out. The cat is well and truly out of the bag.
Eurobonds would stand a better chance of stemming these dynamics but suffer from other problems, like spill-over effects and moral hazard. They either need to be backed by iron clad rules for sovereigns not to free ride on the efforts of others, or a much more centralized budgetary authority. And they require Treaty changes that would take years.
So what we've done is set out some possibilities here; none of them is ideal, all of them create a great deal of risk and involve very awkward choices. But so is doing nothing. The euro debt problem is as good as intractable. Clearly something has to be done. Markets hate uncertainty above all..