Wednesday, July 28, 2010


Sovereign default strategic choice in Europe: Bail out Vs restructuring vs. Debt Moratorium

By Shan Saeed

I was sitting in Chicago on Monday i.e.15th September 2008 studying at Uni. Of Chicago, Booth School of Business for my second MBA when the news spread about Lehman Brothers going down and on the same day AIG was exploring options to get $75 Billion credit line from Goldman Sachs and JP Morgan for bail out. Bail out is just like giving money to an addicted person to get more addiction. Either he straightens up or he dies. I shared my analogy with Prof Gary Becker, Nobel Laureate of economics in 1992 and he nodded and said yes, you are correct. Europe’s financial mess is perhaps the worst in the last 5 decades. Politician are creating fear that bail out is the only solution to the current problem. These high economics cost bail out transactions are drilled down the throats of tax-payers who suffer the most by bolstering the politician views. The current cost would touch $2 trillion with other European countries getting their fiscal structural adjustment in order to eschew sovereign risk default. The best game plan for the current crisis is restructuring the debt due in order to get a breathing space for these southern European countries.

The bail out phenomenon was started by Henry Paulson—Treasury Secretary after the demise of Lehman with rescue package prepared on war-footing for AIG, Citibank, JP Morgan and Merrill Lynch. The European plagiarized in a more modern fashion with key decision makers involved to save German and French banks to cover their book losses since they took huge exposure in the Greece market. The total exposure of German and French banks was amounting to Euro 28 billion and Euro 50 billion respectively. This accounted for 71% of the total debt of Greece when the trouble started getting out of roof and bond yields going upwards…

Was bail out the only solution to the Greece problem? When politician artfully planted a scenario as a choice between bail-out and catastrophe? Any rational person would prefer to avoid the disaster with an uncontrollable default consequences thus becoming painful for the nation. But there was an excellent option of restructuring the debt which was a feasible option in case of default. Greece would have been much stronger internally and externally had it gone for restructuring of its sovereign debt rather than for bailout in this case…..

If we look at the case of Russia when it defaulted in 1998 and how it has turned around in 12 years time is a success story for all to emulate for economic growth. Russia moved into the market based economic system in 1991. With strong economic reforms, privatization and macro-economics stability brought about due to prudent approach to the economy. It achieved noticeable achievement in 6-7 years time and then the tide went against Russia in 1998, led to series of default and pressure on Russian rubble. On 17th August 1998, Russia was forced to default on its domestic debt,, government devalued the currency and declared moratorium on payment to foreign creditors. Stock market went down by 39% in valuation and bond market weakened to send investors in a panicky situation. Lending rates were trading at 30%, banks risk went high, bonds yields went up and revenue stream was low as oil was trading at $11/barrel in the international market. How did it Russia come out of this situation successfully even today?

Russia restructured its debt and paid off in 3 years time to IMF. This is a pure case of financial restructuring that led to its turn-around. Russia got the oil price advantage windfall and has managed to weather the storm from the European financial mess. Its clearly illustrates one point that debt restructuring is a much better choice than bail out which devours the tax payers money and create moral hazard. Russia is in much better shape now as compare to eastern European countries or Baltic region. But countries in recent crisis did not adopt restructuring option but instead went for bail out because politicians in these countries created fear and apprehension among the masses that bail out was the only option left for people to deliberate upon to get the countries out of structural flawed financial architecture.

How does restructuring work and has better chance to make a smooth transition for the economy without costing the tax payers a single penny?
According to Professor Luigi Zingales at Uni. Of Chicago, Booth School of Buisness, USA, Here’s how it could work. The first thing Greece needs to restructure its public finances is time. So the initial step of a restructuring plan would be a forced extension of debt maturity by three years. This extension, amounting to a partial default, would saddle holders of debt issued by the Greek government with a 15 to 20 percent loss. Temporarily liberated from the need to refinance its debt, Greece would need only the money to finance its budget deficit, which it must bring down dramatically in the next few years. Any credible fiscal policy plan must shrink the budget deficit to €20 billion this year and €5 billion the following year. The International Monetary Fund would be in the best position to extend the €25 billion in loans to cover these deficits. The IMF could make the loans conditional on these deficit cuts’ being reached and could also make the loans senior to all the existing debt—as debtors in financing lending do in U.S. bankruptcy law—which would keep the funds from propping up the existing debt.
Such a plan would admittedly be risky because of the impact it could have on banks in Greece. French and German banks would not be affected in a major way; most of the Greek debt that the two countries hold is owned by insurance companies and mutual funds, which can absorb the shock, rather than by banks, which hold just €18 billion of debt in France and €19 billion in Germany. Thus the worst-case 20 percent loss that Greece’s partial default could impose on debt holders would represent €4 billion for each country’s banks—a significant blow, but not enough to imperil the entire European banking system. The Greek situation is different. According to Barclays’s estimates, Greek banks hold €42 billion of Greek debt. There, a 20 percent loss would equal €8 billion, potentially too much to bear. The failure of Greek banks could then easily spread a panic throughout Europe.
So a restructuring plan would require an IMF intervention in the Greek banking system: not a bailout, but a temporary takeover of insolvent banks. The IMF could act as a receiver, guaranteeing the banks’ systemic obligations [deposits and interbank debt] while wiping out shareholders and also, to the extent the losses require, long-term debt holders. Then it could temporarily recapitalize these banks and sell their shares in the marketplace as soon as the market stabilized. This part of the plan would not require more than €8 billion, and the IMF would be likely to recover all of that (and more) at the time the banks were sold. So the total amount of funds required would not exceed €33 billion, an amount that the IMF could feasibly cover on its own.
This strategic restructuring plan would cost European taxpayers nothing while preserving marketplace incentives. The current bailout plan, by contrast, rewards banks and individuals who invested in risky Greek debt, contributing to moral hazard and distorting future market signals. But the restructuring that I propose would never be discussed in Europe, let alone approved. In Paris and Frankfurt, as in Washington, the will of the banks matters more than the will of the people.

Writer is MBA from Uni. Of Chicago, Booth School of Business, USA in March-2009. And MBA from IBA, Karachi in May-1998.

These views and analyzes are done by Shan Saeed. Financial markets are changing every second. Clients and investors are advised to perform their own Due Diligence before investment. Market risk and country political risk are applicable with each countries. Sovereign debt default risk is with all countries. All investment related research /articles are based on the authors personal views…I strongly advise investors/people/ institutional clients/pensioners to follow their own investment strategy according to their risk appetite and profile.


  1. Bailout and Restructuring is like prison break for many of the leading bankers in Europe-who are actually in manipulative control of Europe's banks. Just the other day I watched the movie 'The International'. While theatrical, the movie sure portrayed quite a sense of what the European banking is about; albeit scantly.

    Post WW2 when actual restructuring was in progress and bailouts were--well non-existent, other means of rather politically controversial restructuring picked up, funding the obliterated and deindustrialized countries to industrialize again. This is actually important, as it seems a bit off-topic but awkwardly creates a turning point by the big game players. Notably Germany, France, Luxembourg, Liechtenstein and Switzerland among the great game players that are considered.

    So while bail-out may seem like giving money to an addicted person, it is infact the analogy of making the addicted person a dispensable mercenary.