The pitfalls of EZ sovereign debt restructuring

by Lucas Papademos

Vox
October 26, 2011

Lowering Greece’s debt burden is a core goal of today’s EU summit. This column – written by Lucas Papademos (former Greek Finance Minister and former ECB Vice-President) – argues that the most effective and prudent way is to implement the July agreement, reinforced by ‘firewalls’ to protect financial institutions and avoid contagion. Both require a substantial increase in EFSF ‘firepower’. Bank recapitalisation is necessary, but not sufficient.

As the Greek debt crisis has escalated, the calls for restructuring the country's public debt have correspondingly increased. Debt restructuring is advocated in order to lighten Greece's debt burden, ensure the sustainability of its public finances and improve the economy's long-term growth prospects. In addition, it is argued that debt restructuring resulting in losses for bond holders, mainly financial institutions, would reduce the risk of moral hazard created when countries that had previously pursued irresponsible fiscal policies receive official financial support.

Such arguments are valid, but incomplete. They fail to take into account the substantial costs and risks associated with a restructuring process. A more comprehensive analysis reveals that the likely net financial benefits from debt restructuring, in terms of reducing the size of Greece’s public debt and the cost of servicing it, would be much smaller than often envisaged, while the adverse consequences and potential risks – both for Greece and for the Eurozone as a whole – are likely to be significant, with profound and far-reaching implications for financial stability and economic performance.

The net financial benefits of sovereign debt restructuring by a Eurozone country that leads to losses for bond holders due to a haircut in the nominal value of outstanding debt depend crucially on two factors:

• First, the distribution of sovereign debt across creditors and the extent to which they would be able to absorb such losses without government support, and
• Second, the funding constraints and financial interlinkages stemming from the functioning of the European monetary union and the integration of financial markets.

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