According to recent press reports, Eurozone governments in the past weeks have been considering plans to enable Greece, and possibly Ireland, to use the resources of the European Financial Stability Facility for buying back some of their own debt on the secondary market. Presumably the idea is to “pass on” the market discount to the borrowers in order to alleviate their financing need. Many crucial details of the plan remain unknown. Under one scenario the European Financial Stability Facility, which is rated AAA, would borrow from the international markets and lend money to Greece, who would use the money to buy back the debt (possibly from the ECB). Alternatively, Greece would issue senior debt backed with a guarantee from the Stability Facility, effectively retiring its debt at a 20%-30% discount.
While there seems to be a growing consensus that some sort of restructuring may be desirable for highly indebted European countries facing insolvency, the state of the European discussion betrays a muddled thinking about the starkly different implications for debtor and creditors of the different ways to go about restructuring. As far back as 1989, Paul Krugman discussed the logic of “market-based” debt-reduction schemes in a nice paper (Krugman 1989, see also Krugman 1995). His approach is useful to clarify some of the issues at hand and can be used compare the various ways to go about restructuring: a unilateral debt reduction, a buyback, or a swap of senior for junior debt.
An example: A unilateral write-off, a buyback, and a euro swap
Consider a country which has to repay €100 billion (so that all the following numbers can be thought as percentages of debt coming due), and is facing some (exogenous) uncertainty over the resources (tax or export revenues) that will eventually become available for the purpose. For example, revenues could be low (€66.7b), with a high probability (), or high (€100b) with low probability (). Our country is insolvent ex-ante, since it is expected to pay only €80 billion ( (see the fist column in Table 1). Therefore, its debt will trade below par, and precisely, assuming risk-neutral investors, at 80 cents, the ratio of expected payments to debt coming due (this is approximately the price of a Greek bonds on the secondary market). Consider now a unilateral write-off of €20b (see the second column in Table 1). Creditors will get only €72 billion in expected terms ( , €8 billion less than before – the loss comes from having lost the option of profiting from the good state. Thus a relatively large (20%) write-off implies here only a modest (8%) loss/gain for debt holders/issuer, and results in a rise of the secondary market price of the debt (from 0.8 to 0.9 = 72/80).
Table 1. Restructuring sovereign debt
This contrasts sharply with the consequences of a debt buy-back, similar to the first proposal currently under discussion. A buy-back entails a large benefit for creditors and an even larger loss for the issuer, see the third column. Suppose that the country uses €20 billion (of new European Financial Stability Facility money) to buy back its debt on the secondary market. This must raise the bond price up to the point where investors are indifferent between selling and keeping the debt, which turns out to be 0.912 cents in the example. At this price the government purchases about €22 billion of the debt, leaving €78.07 billion outstanding.1 Note that while the effect on the bond price is similar to the unilateral default case, the welfare implications are markedly different: creditors gain substantially from the buyback (they gain €11.23 billion, since total payments rise from €80 billion to €91.23 billion), while the debtor looses even more (the larger payments plus the €20 billion borrowed from the European Financial Stability Facility). If the purpose is having creditors to share the costs of insolvency, buy-backs are clearly not the way to go.
Finally, consider a swap where the government issues €20 billion of new (euro) bonds, which are guaranteed by the European Financial Stability Facility, and uses the proceeds to purchase the old national debt. Since the new debt is senior, it has priority in reimbursement and sells at par for €20 billion. The secondary market price of old (now junior) debt must immediately fall to the point where investors are indifferent between the swapping or holding the old debt, 0.777 cents in the example.2 As a consequence, creditors lose and the debtor gains, albeit only marginally, €2.3 billion (note that, unlike in the Juncker Tremonti Euro Bonds, proposal here the liability rest with the original country, see also Manasse 2010 for a discussion).
This example shows that if the purpose of the restructuring is to reduce the burden of payments for the debtor and to have creditors sharing the losses, a unilateral partial default or a debt swap seem largely preferable to a buyback.
Krugman, Paul (1989), “Market Based Debt Reduction Schemes, Working Paper No. 2587”
Krugman, Paul (1995), Currency and Crises, Ch.3 and 4, MIT Press.
Manasse, Paolo (2010), “My name is Bond, Euro Bond”, VoxEU.org, 16 December.
1 Holding the debt yields expected payments of , corresponding to a percentage return of 0.912 =71.23/78.07, which is the same as the secondary market bond price.
2 With a secondary market price for old debt at 0.777 cents, the €20 billion of new debt is swapped for €25.74 billion of old debt, leaving €74.26 billion old debt outstanding. Given that the new debt has priority in reimbursement, by holding the old debt investors obtain, in expected terms €57.7 billion = , which corresponds to a return of 0.777 (=57.7/74.26), which equals the secondary market price.