In "With the Euro Disintegrating, You Can Calculate Your Haircuts Here", I explicitly illustrated the likely loss to principal of sovereign debt investors who would be forced to take haircuts "for the cause". While we fully stand behind the calculations and the logic, chances are several sovereigns may attempt to undergo sleight of hand in order to placate investors as best they can. We suspect we will soon be hearing of significant restructuring plans in the Eurozone, starting with Greece. The piece below expands on these thoughts and offers subscribers live spreadsheets that illustrate the potential repercussions. It is recommended that these scenarios be taken into consideration in light of the info offered in the post "Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!" and compared to the haircut analysis as well. All paying subscribers are welcome to review our analytical overview of Greece's public finances (Greece Public Finances Projections) as well as the full Pan European Sovereign Debt Crisis analysis which is freely available to everyone.
Greek Restructuring Scenarios
There are several precedents of sovereign debt restructuring through maturity extension without taking an explicit haircut on the principal amount, and many analysts are predicting something of a similar order for Greece. This form of restructuring is usually followed as a preemptive step in order to avoid a country from technically defaulting on its debt obligation due to lack of funds available from the market. It primarily aims to ease the liquidity pressures by deferring the immediate funding requirements to later periods and by spreading the debt obligations over a longer period of time. It also helps in moderating the increase in interest expenditure due to refinancing if the rates are expected to remain high in the near-to medium term but decline over the long term.
However, the two major negative limitations of this form of restructuring if applied to Greek sovereign debt restructuring are –
- It solves only the liquidity side of the problem which means that the refinancing of the huge debt (expected to reach 133% of GDP by the end of 2010) will be spread over a longer time period while the debt itself will continue to remain at such high levels. The sustainability of such high debt level, which is growing continuously owing to the snowball effect and the primary deficit, is and will continue to be highly questionable. Greek public finances are burdened by a very large interest expense which is approaching 7% of GDP. The government’s revenues are sagging and the drastic austerity measures need to first bridge the huge primary deficit (which was 8.6% of GDP in 2009), before generating funds to cover the interest expenditure and reduce debt.
Thus, even though the amount of funds required each year to refinance the maturing debt will be reduced by extending maturities, the solvency and sustainability issues surrounding Greece’s public finances, which were the primary reasons for it’s being ostracized from the market in the first place, will remain unanswered.
- It will lead to a very material decline in present value of cash flows for the creditors since the average coupon rate is lower than the cost of capital (reflected by the yields on the Greek bonds). The average coupon rate for bonds maturing between 2010 and 2020 is about 4.4% while the average benchmark yield for bonds with maturities from 1-10 years is nearly 7.5%. Also, as the maturity of the debt is extended, the risk increases and so does the cost of capital.
In order to assess the effectiveness of this form of restructuring for Greek sovereign debt, we have built three scenarios in which the maturities of the Greek debt is extended. These scenarios weren’t designed to be exact predictions of the future but to represent what may happen under a variety of highly likely scenarios (a pessimistic, base and optimistic case, so to say):
- Restructuring 1 – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having same coupon rate but double the maturity.
- Restructuring 2 – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having half the coupon rate but double the maturity.
- Restructuring 3 – Under this scenario, the debt maturing between 2010 and 2020 will be rolled up into one bundle and exchanged against a single, self-amortizing 20-year bond with coupon equal to average coupon rate of the converted bonds.
In all the three scenarios, we computed the total funding requirements and compared the same with funding requirements prior to restructuring. It is observed that restructuring will help in easing the immediate pressure of procuring funds to meet the huge funding requirements lined up in the next 5 years. However, it will also lead to substantial loss to creditors in the form of erosion of present value of cash flows. (Discount rate was the benchmark yields of Greek government bonds for similar maturity period).
- Under restructuring scenario 1, the decline in present value of cash flows is 9.3% and the cumulative funding requirements between 2010 and 2025 reduces to 155.2% of GDP from cumulative funding requirements of 177.7% of GDP if there is no restructuring. The cumulative new debt raised will decline to 78.6% of GDP from 80.7% of GDP if there is no restructuring
- Under restructuring 2, where the doubling of maturity is also accompanied by halving the coupon rate, the decline in present value of cash flows is 26.3% and the cumulative funding requirements between 2010 and 2025 reduces to 116.9% of GDP. The cumulative new debt raised will decline to 40.3% of GDP
- Under restructuring 3, the decline in present value of cash flows is 18.0% and the cumulative funding requirements between 2010 and 2025 reduce to 131.5% of GDP. The cumulative new debt raised will decline to 69.0% of GDP.
We have also built in the impact of EU/IMF assistance to demonstrate the impact on funding requirements over the period 2010-2025. We assume that IMF/EU will disburse the entire assistance of EUR 110 billion by 2013. The IMF loans will have to be repaid after 3 years from the disbursement date and the payment will be distributed over the next two years. The EU loans will have to be repaid after 3 years from the disbursement date and the payment will be distributed over the next five years. It is observed that IMF – EU assistance will be just a short term relief and Greece will face the pressure when it will be forced to turn to the market to not only fund its maturing debt but also repay EU-IMF loans.
Conclusion – It is seen that the restructuring by maturity extension will marginally moderate liquidity concerns. But the primary and the more fundamental concerns about the high level of debt and the related refinancing and interest rate risks, the huge interest burden, the poor primary balance will be left unresolved by this form of restructuring. The revenues are weak and expenditures are high resulting in huge primary deficit and the government need to first fill this huge gap before it earns a primary surplus to cover the interest expense and reduce debt levels.
The government debt currently stands at 124.5% of GDP and is expected to balloon to 156.1% of GDP owing to lack of funds from primary balance to cover the interest expenditure which continues to add to the government debt levels. The three scenarios built for maturity extension show that maturity extension will not substantially help this issue to contain the ballooning government debt. Under restructuring 1, 2 and 3, the government debt is expected to stand at 154.4%, 123.7% and 147.0% of GDP at the end of 2025.
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