Will Greece Resolution Spark a Bigger Crisis?

By John Carney

Mar 8 (CNBC) — Markets around the world were buoyed on hopes that Greece’s long and winding journey to debt restructuring may at last be its final port of call.

But some are warning that this may actually be the beginning of a new and more dangerous crisis.

The private sector is being asked to write off more than 70 percent of the face value of their Greek government bonds in return for new debt. This will help Greece meet its debt obligations and enable it to tap into bailout funds from the EU and IMF.

It seems likely that other nations burdened by heavy debt loads and high interest rates may seek to follow Greece’s path to debt relief. If Greece doesn’t have to pay what it owes, they might argue, why should we? Call it Haircut Contagion.

European officials insist that Greece is a one-time deal, not meant to set a precedent for other nations. But it is easy to see that minority parties in debt-burdened European nations could find a demand for relief an attractive platform. Imposing a “tax” on bondholders rather asking citizens to pay higher taxes while public services are cut might prove popular with voters.

Demands for debt relief could take many forms. Greece has been able to encourage bond holders to participate in the debt swap by enacting laws that incorporated “collective action clauses” into the 86 percent of bonds governed by Greek law. These clauses allow super-majorities of bond holders to force hold-outs to participate in swaps. Other countries in the euro zone could replicate this strategy.

“Effectively, this is a large gift from the Greeks to the parts of the euro zone that face debt crises. By conducting its debt exchange in the way it did, Greece has in effect resurrected the plausibility of purely voluntary debt-reduction operations in Europe,” Moody’s has explained.

Such demands would put new strains on the global financial system. While Europe’s banks and insurance companies can withstand losses on Greek debt, a series of similar haircuts might destabilize the system and render some institutions insolvent.

Warren Mosler, a trader based in the Virgin Islands who is credited with creating the euro-swap futures contract, fears that all it would take to set off a panic would be serious political discussion of widespread haircuts.

“The idea of Greek default transformed from being a Greek punishment to a gift, with the pending question: ‘If Greece doesn’t have to pay, why do I?’ — threatening a far more disruptive outcome that is yet to be fully discounted,” Mosler writes on his website, Mosler Economics. “That is, should Greek bonds be formally discounted, the consequences of merely the political discussion of that question will be all it takes to trigger a financial crisis rivaling anything yet seen.”

He has spelled out exactly what he thinks would happen in a Haircut Contagion crisis.

“Possible immediate consequences of that discussion include a sharp spike in gold, silver, and other commodities in a flight from currency, falling equity and debt valuations, a banking crisis, and a tightening of ‘financial conditions’ in general from portfolio shifting, even as it’s fundamentally highly deflationary. And while it probably won’t last all that long, it will be long enough to seriously shake things up,” Mosler writes.

A recent paper cited by Reuters took a much more sanguine approach to the likelihood of Haircut Contagion. The ratings agency figures that countries may attempt to receive modest debt relief in exchange for giving up their rights to unilaterally change the terms of their debt. They could do this, for example, by restructuring bonds governed by domestic law into foreign law bonds, mostly likely governed by English law.

“Holders of local-law governed bonds in other euro zone countries that are perceived to be at risk might want to make a trade for English-law governed bonds,” Jeromin Zettelmeyer, deputy chief economist at the European Bank for Reconstruction and Development, and Duke University Professor Mitu Gulati, wrote in the paper. “Depending on how much these bondholders would be willing to pay to make this trade, it could serve the interest of the country as well to make it.”

Of course, countries that agreed to make this swap would be sacrificing a lot of their future flexibility. Some might find it too high a price to pay. In a sense, converting their debt to foreign jurisdiction bonds would be like doubling-down on the structural problems with the euro zone. The countries that did this would sacrifice sovereignty over their debt to achieve lower interest rates, much like they sacrificed monetary sovereignty for the currency union.

And it’s not clear that this would be all that attractive to bondholders, either. After all, a country that cannot or will not pay its debt cannot be forced to, just because the bonds are subject to foreign law.

The hope of European leaders was that preventing a disorderly default in Greece would avoid a domino effect of sovereign debt defaults. The danger, however, is that debt relief for Greece could spark a new and unexpected Haircut Contagion crisis.

46 Responses

  1. Warren,
    Why do you think ‘it probably won’t last that long’ if such financial crisis will happen?


        If more and more people expect such ‘ECB PUT’ to be in place then the sell off is not likely even to happen. But I agree with you that there is a difference between all the time water supply versus only when the plants are about to die.

        In the meantime, around 85% participation rate for GR debt swap and over 95% when cacs will be used.

  2. Great article.

    Isn’t it that a loan is based on credibility; always? If a Eurozone country “can pay,” why would it risk losing its credibility by trying to produce a “haircut”?

    All these “volatilities” only make traders (not investors) happy.

  3. Could somebody explain me how a land like Greece, that barely has export, can manage its foreign debt even if they would have their own currency?

      1. @WARREN MOSLER, but this is exactly the thing I haven’t figured out yet quite right.

        If a land dosen’t have enough to export, it has to buy goods that it can’t produce from abroad. Now what I’ve learned from different MMT Blogs and Forums, everything is good as long as the land has debt only in its own currency. But what if those other lands don’t want the currency. In case of USA I can understand that China has nothing against it that USA has debt for China in Dollars. But for example Greece is such a small land with a “small” currency that I can’t see why e.g. Germany and France would accept Drachma.

      2. @MamMoth,

        “Most countries don’t pay for their imports in their own currency”

        You have evidence to back that up I presume?

        Because it is clearly in a business’s interest for the seller will make it as easy as possible for the buyer to buy.

        Now that may mean arranging letters of credit up front to ensure the whole chain works (including the currency exchange), but it doesn’t mean that they don’t pay in their own currency. It means that the whole chain, physical and financial, has to be pre-agreed.

      3. the way it works is foreigners see goods and services offered for sale-houses, workers, hotel space, etc- in exchange for, say, drachma, that residents need, directly or indirectly, for payment of taxes.

        then they know if they sell their trinkets to Greece, they can buy that stuff too.

      4. @MS, The standard picture would be: Greek importer buys and pays in foreign currency and sells in Greece for local currency. The currency risk is hedged via extra mark-up.
        But keep in mind importers sometimes go bankrupt and disappear………

      5. @Warren Mosler,

        consumers pay for imports with their own currency

        Sure. But in most countries importers don’t buy the imports with their own currency.

      6. @Mammoth

        You are missing the inference.

        They most certainly do ‘buy’ the imports with their own currency, because that is the currency the importer is operating in natively.

        Therefore the thought processes about profits come from working in the local currency, not the foreign one.

        Now that may not be the currency of the contract – but that is irrelevant. The import process involves the actual supplier *and* the exchange funder of the process (and in some countries, like Ukraine for example, foreign goods and services are *required* to be priced in a foreign currency – then submitted to central authority for exchange funding).

        Running through any import process pretty much always requires that the funding chain is set up *first* before any actual goods or service are supplied. Nobody ships any material quantity of anything to foreign parts without some trusted third party guaranteeing payment. And that guarantee is likely to be in the local currency.

        In fact with services like Paypal you have the choice of which currency to hold. Brazilian Real, Phillipine Peso, Malaysian Ringgit – no problem any more.

        A quick flick around the Internet shows that Indian direct exchange websites are pricing goods located and shipped from Hong Kong in Rupees. And local councils in South Africa requiring that foreign suppliers give a fixed price in Rand.

        So at best stating what you do is a very narrow view of the actual situation – too narrow to be of use in economic analysis. Particularly at the aggregate level. I don’t believe the evidence supports it.

    1. @MS,

      Barely has export? It has a huge tourist industry.

      If it had its own currency the cost of holidays there would be very cheap for everybody outside Greece.

      The limiting factor would probably be the capacity of the airports and water taxis to the Islands.

      1. @Neil Wilson,

        If it had its own currency the cost of holidays there would be very cheap for everybody outside Greece.

        Why would being a cheap holiday destination depend on them having their own currency? They could become tomorrow if they wanted, just start charging half of what they charge now.

      2. @MamMoTh,

        Are you talking about reducing prices all across the Greece by legislation? Debts would have to be cut too in that case.
        Also, everybody would scream about government intervention.
        If it is just hotels that would cut prices without reducing costs – they would go out of business, I suppose.

      3. @Neil Wilson, That is true, they have potential in tourist industry. But what I’m actually asking is what if a land don’t have even that? I mean, have I understood MMT right if I say that own currency alone can’t save the economy if a land don’t have enough resources nor tourist industry?

      4. @MS,

        if people cannot survive and have nothing to trade for survival items – then what economy are we talking about?
        I don’t think currency matters in such case.

        If they can survive, or can trade something (even if its their own capacity to work) for the things they need – and if they decide to have a government – then own currency is better than foreign – because it gives them more flexibility to do things the way they want.

    2. @Warren Mosler,

      if they don’t greece is condemned to balanced trade

      Or to be indebted in a foreign currency.

      Argentina’s export-driven model is becoming more interesting by the day. In order to ensure at least a balanced trade, importers willing to increase their imports are required to much the increase with exports, turning car importers into wine and soya producers and exporters.

  4. “The ratings agency figures that countries may attempt to receive modest debt relief in exchange for giving up their rights to unilaterally change the terms of their debt. They could do this, for example, by restructuring bonds governed by domestic law into foreign law bonds, mostly likely governed by English law.”

    Is this the “English Law” that governed GM bonds? As the GM bondholders about the great protection that law gave THEM against GM and their unions unilaterally changing the terms of their debt.

  5. Hungary is a country with own currency, they have barely export, not enough tourism and therefore more debt in a foreign currency than its own. They cannot achieve full employment without inflation or foreign debt. How do you save a country like that? Could IMF maybe be the answer?

  6. @MS,

    MS: “Hungary is a country with own currency, they have barely export”

    You’d better check the stats. Hungary has a very strong export sector and IS a net exporter.

      1. @MamMoTh,

        “why the foreign debt then? Is it just a private sector debt?”

        That is more complex. Firstly, net export does not mean positive current account. But that is not the point.

        If you look at the official fx reserves of Hungary you will see something like EUR 40bn+ which is more than double of what Hungary got from IMF and what it tries to roll over. But that is also not the point.

        The point is that the way monetary policy was conducted in Hungary, as well as in many other places, is for the EUR convergence. National bank of Hungary used interest rates to ensure the stable and converging *exchange*rate*. This made interest rates in local currency too volatile for both banks and non-bank sector to digest. And this triggered the popularity of fx-lending with low(er) and stable interest rates. Primarily CHF but also EUR. As HUF is the transaction currency in Hungary inflows of foreign currencies were sterilized by the central bank in the way, for instance, China does. While there were many complex dynamics, the economic bottom line of this mechanism is that population was becoming indebted in foreign currency while the central bank was accumulating fx reserves. So they were and still are on the different sides of the effectively same fx bet.

        As for government debt, government now tries to socialize part of the fx-risk by taking fx-loans from IMF etc. That is a common way to bail-out certain seriously money losing parties on behalf of the population being subjected to IMF-style fiscal austerity.

  7. English law jurisdiction bonds might have a temporary effect on rates charged but any debt problems will cause the rates to rise again! There is no permanent gain for a sovereign authority to do something so stupid!

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