Thank you Mr Roubini, but can I see the menu again?

By Jean Pisani-Ferry
02 June 2011

(A version of this column was also published on Eurointelligence)

For several months Europe has been the theatre of a confusing and often acrimonious debate about the
restructuring of Greek debt. The debate is confusing because people use the same words to mean different
things. Restructuring for an economist means a reduction of the present value of the income stream the
holder of a debt security can expect. But it means something different for an accountant (who cares about
valuation in the books of the holder), a financier (who cares about the triggering of Credit Default Swaps) or a
lawyer (who cares about procedures and creditor rights). The debate is confusing also, and in addition
acrimonious, because many of those who oppose a restructuring of unsustainable debts have refused to
enter a facts-based discussion and have preferred instead to warn about the risk of a financial Armageddon.
Nouriel Roubini must be thanked for attempting to move the debate to a different level. Drawing on the
international experience, he and his team have in a series of recent pieces analysed options in detail and put
forward concrete proposals1. His aim is, rightly, to minimise the financial disruption a involved in a
restructuring.

This is not to say, however, that Roubini’s proposal is entirely convincing. In essence, he is suggesting to
exchange on par outstanding debt securities, against new ones carrying lower interest rates and with a longer
maturity. This would avoid triggering a credit event as banks would be able to keep on holding these
securities in their banking book without incurring a write-down. At the same time, banks would maintain their
exposure, which would reduce the need for new official credit, and Greece would benefit from lower interest
rates, which would reduce the debt burden. Finally, Roubini claims that contagion to other Southern European
countries would be minimal, because markets would assess the situation of each country in its own right.
This looks like an appealing option. But there are two problems with it.

First, the exchange is unlikely to reduce the debt burden sufficiently to ensure sustainability and help restore
market access. Most of the stock of debt was issued at a time when spreads were very low, so it is to be
feared that the saving on debt service will be not be enough to change the equation materially. An insolvent
country cannot be rendered solvent by a maturity extension and a limited interest relief. Furtheremore,
markets have learned the hard way that safe debt levels are lower in a monetary union than they thought
they were. This may in the future imply much lower threshold for market access.

Nouriel Roubini is aware of this problem. He is careful not to suggest that his debt exchange would restore
solvency and leaves more than open the possibility of a full-scale restructuring sometimes in the future. But
why, then, should any bondholder enter the suggested exchange, absent the guarantee that the new bond will
not be restructured? As an incentive Roubini proposes that the ECB rules the old bonds ineligible as collateral
in repo operations and only accept the new ones. Even abstracting from the current stance of the ECB – the
institution most opposed to any restructuring -, this would neither be very legitimate nor acceptable by the
bond holders.

The second problem is the claim that contagion would be minimal because markets would assess each

1
Much Ado About Relatively Little : Contagion Risks From and Orderly Greek Debt Restructuring Are Modest,
Contained and Manageable. RGE, 24 May.
© Bruegel 2011 www.bruegel.org 1
country’s debt sustainability separately. Fear and herd behaviour apart, this neglects the fact that a par
exchange would signal a major change of stance by European authorities. Inevitably, markets would
immediately wonder ‘who is next?’ and price sovereign bonds accordingly. They would rationally consider that
authorities stand more ready to engineer some form of debt reduction. So there would be a price to pay for
Ireland, Portugal, probably also Spain and even others.

The one problem that Roubini’s option solves is that it implies that creditors (at least the banks) maintain
their Greek exposure. This avoids the exit of private creditors as maturities come due and their substitution by
public creditors to – up to a point when any solvency-restoring debt restructuring would imply wiping out the
entire value of the remaining private creditors’ holdings. This is indeed a legitimate objective. But this
objective can also be achieved, partially at least, through exercising moral suasion on the same creditors so
that they maintain their exposure on Greece, as was done in several past occasions.

Such a tactic would amount to no more than buying time, in the hope that by the time genuine Greek
restructuring becomes unavoidable, it has become clearer (a) which countries need to follow suit and which
can serve their debt in full, (b) which banks will be severely affected and will need to be recapitalised, and (c)
how financial disruption can be minimised. A postponement of this sort cannot be last for very long and is
bound to cost some money. But if the limited time gained is used to prepare for the inevitable, and if it helps
ring-fence Spain and perhaps avoid an Irish restructuring, it is a price worth paying.

© Bruegel 2011 www.bruegel.org 2