Thursday, 12 May 2011

Options on default

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


Paul Hunt said...

"...penal cuts to public pay and welfare are not in any way an inevitable and may in fact be prevented."

At least there's some honesty about the key objective of this post. Let's get back to bubble period BAU asap.

No possibility of questioning why, as one voluble defender of current PS pay and welfare rates puts it, "Ireland is a very expensive place to live". or how

Haircutting senior bondholders is fine if one wants to end up with a totally publicly owned banking system relying solely on domestic financing - but maybe that's the desire and the intent. And the rest of the Irish private sector would be shut out of international capital markets.

Forcing the ECB to cash in the collateral it holds for bank liquidity support would put Ireland into full-scale conflict with the EU and its institutions, seriously damage these institutions and place Ireland's continued membership in jeopardy; but, again, perhaps that's the desire and the intent.

North Korea, here we come.

Paul Hunt said...

I see the comment I posted here has disappeared. Says it all really.

progressive-economy@tasc said...

@Paul Hunt: As you probably know, Blogger was down on Friday - and took some comments with it! Could you re-post your comment? Thanks ... Admin

Paul Hunt said...

Thank you, admin. However, it is becoming increasingly clear to me that my brand of dissent which seeks constructive engagement is not welcome here. I should have known it would prove impossible when there is such a desire to wallow in the comfortable, tired and increasingly irrelevant ideological nostrums that markets are always and everywhere evil and that the state is always and everywhere a paragon of virtue.

Robert Sweeney said...

Have you read this piece by Mark Weisbrot? As you may know, he's an authority on Latin America and an economist who delves outside the neoclassical framework. Unlike Reinhart and Rogoff (I believe), he was critical of the financial de-regulatory policies long BEFORE the crisis. He notes:

'Then Argentina defaulted on its foreign debt and cut loose from the dollar. Most economists and the business press predicted that years of disaster would ensue. But the economy shrank for just one more quarter after the devaluation and default; it then grew 63 percent over the next six years. More than 11 million people, in a nation of 39 million, were pulled out of poverty.'

Also, if Ireland left the euro, would household savings held in Irish banks be immediately converted into punts, or would they remain denominated in euros? Are there any policies that could be pursued to increase FX reserves that would lesson the impact of the increase in price of imports that would occur after the inevitable devaluation? For example, how about a small export tax on the excess profits from a devalued currency? The revenue could be used to help households and businesses suffering from increased energy costs. Would that be feasible? Also, could we use some sort of capital controls to increase FX holdings and prevent a further run on banks? Surely being able to create money would somewhat mitigate the banks liquidity problems should such an event happen if Ireland left the euro.

Tom McDonnell said...

@ Paul

Your dissent is always very welcome.

Later this week I will put up a post on the document you linked to last week.

Paul Hunt said...

@Tom McD,

Thank you. Do you know if anyone from this board or from the 'progressive-left' generally attended the Oslo conference and might be in a position to report on the proceedings?

Tom McDonnell said...

@ Paul

No one went that I am aware of.

Paul Hunt said...


If true, that's a shame. The problems we are confronting will have to addressed at a European or even global level. Unfortunately there is a tendency on this island to navel-gaze and fester - and to focus on international issues as a means of securing comparative data to score a debating point on a matter of contention in Ireland.

There probably isn't much point posting on the 'Memos to the Left' document to which I linked. A bit too challenging and best ignored.

Anonymous said...


maybe you could give us an eejit's guide to the document?

Paul Hunt said...


To be honest I don't think I could do it justice. It is wide-ranging, stimulating and challenging - and very relevant. But this is my take on the context and why it is so important:

The current economic and financial crisis is feeding broad, poorly-defined discontents about immigration, Islamic culture and terrorism, globalisation and economic insecurity.

And these discontents are being exploited and channeled by right-wing, populist, nationalistic xenophobic parties throughout the EU to secure power and influence. Gert Wilders’s faction of this ilk is supporting a minority centre-right government in the Netherlands from the outside. Similar arrangments (either within or outside government) may be found in Denmark and Finland. The Swedish Democrats prevented the outgoing centre-right government in Sweden secuirng a majority. The split in the corresponding Austrian faction disguises its popular support. Belgium is coming up to a year without a government for this and other reasons. The disgrace of DSK in New York is adding a futher boost to the National Front in France. Italy always struggles to keep a lid on ugly political forces – and a secessionist tendency by the North. The buffoonery of its PM is counter-balanced by a reasonably competent, technocratic ‘permanent government’. Germany alone, for a variety of reasons, has been able to prevent the rise of these factions.

This is the politcial landscape that much of the core EU is confronting – and it’s not a pretty sight. Nor does it offer much hope to the hard-pressed peripherals. It is the inevitable outcome of the exercise and abuse of excessive executive dominance and decision-making by elites that fails to engage and secure democratic consent.

For some time centre-right governments have been in power throughout the core EU and voters, understandably, would like to give them a kicking. But the centre-left, as the traditional alternative, is in terminal decline. Any attempt by the centre-right and the centre-left to coalesce to keep out the ‘hard right’ will fuel even more popular anger and discontent.

The core EU is stting on a powder keg. The only question is when and in what way it will explode.

Tom McDonnell said...

@ Paul

I share much of the authors' gloomy outtlook.

The immediate danger is that it is now clear that EMU in its current incarnation has failed. In turn a failure to understand the reasons for why the EMU is failing is fuelling much of the distrust and bitterness between countries, particularly in the populist media.

Everyone feels they are getting a bad deal.

The Irish media (with notable exceptions) has not distinguished itself in its reporting of the crisis and certain populist outlets have adopted a borderline racist approach. This disturbing phenomenon has been replicated in many other countries. The misreporting of the facts to forment 'outrage' is in my view one of the main reasons for the right wing political trend Paul has outlined.

The farcical nature of Europe's handling of the crisis is worrisome. Europe has played this tape before. It ended badly.

Paul Hunt said...

But it doesn't have to end badly. The paper by Andres Velasco, former MoF in Chile, is very relevant.