With the Failure of Plan A, Europe Turns to Plan B

As predicted on this blog, the failure of the Irish and Greek bailouts to halt the spread of contagion to the core of the EU represents the end of extend and pretend policies and the opportunity to solve the underlying solvency problems.

What is an extend and pretend policy?  It is any policy that avoids determining and dealing with the true size of the hole in a country's financial system by pushing the problem into the future.  All of the extend and pretend policies pursued since the start of the credit crisis in 2007 are based on the notion that economic growth will reverse and even eliminate the credit losses, particularly the real estate credit losses.

As reported in the Irish Independent, there is simple proof that pursuing extend and pretend policies and not addressing the underlying solvency problems is not working in Ireland.

WITH the cost of insuring Irish government debt against the risk of default having soared since the beginning of the year it is now clear that the bailout isn't working and that some kind of sovereign debt default and/or restructuring now represents the only possible way out of the crisis.

This week the cost of insuring Irish government debt against default briefly climbed to 680 basis points (6.8 per cent, 100 basis points equals one per cent), an all-time high.

At that price, the markets were pricing in the likelihood that holders of Irish government debt would suffer a "haircut" of up to 34 per cent in the next five years.

After all the hoopla surrounding the November 2010 EU/IMF 'bailout' for Ireland, it is clear professional investors have run the numbers and concluded that -- apart from the German, UK and French banks who so irresponsibly lent to the Irish banks and have been repaid their senior bonds in full -- the rescue package won't work.

As a result, the cost of insuring Irish government bonds has increased by more than 120 basis points since mid-December.

... With the markets now having concluded that some sort of Irish debt restructuring is inevitable within the next few years, it should hardly have come as any surprise that the Irish banks remain under pressure, with the latest Central Bank figures showing that emergency lending to the Irish banks increased by more than €6bn to €51bn last month.

While this was partially offset by a €4bn reduction in lending from the ECB to the Irish banks, it is clear that the exodus of deposits shows no signs of easing.

In his column in the January 17, 2011 Financial Times, PIMCO's Mohamed El-Erian calls for stopping the current policies and addressing the solvency problem:

The sequencing of Europe’s debt crisis is depressingly similar – the plot stays the same, with a slightly different cast depending on the country in the spotlight. Yet, judging by the run-up to the meeting of European Union finance ministers in Brussels on Monday, European officials seem intent on repeating it over and over again.

Last week, higher borrowing costs raised concerns as to whether Portugal could successfully tap the market in a regularly scheduled government bond auction. Fearing that the country would join Greece and Ireland in both losing access to new market funding and facing alarmingly high risk spreads on existing debt, the official cavalry jumped into action.

Portuguese officials sought to reassure the markets of their fiscal credentials. The EU talked of enhancing the flexibility of its rescue funds. The European Central Bank stepped up its market intervention, buying millions more Portuguese bonds. To make absolutely sure that the auction would succeed – and it did – China and Japan signalled their willingness to buy European debt instruments.

This is the same game plan that was used for Greece and Ireland. The probability of success is the same – very low.

You do not solve a debt problem by adding new debt on top of old debt. Yet it seems that European officials are fixated on this approach. How else would you explain the two main proposals discussed ahead of today’s meeting – namely, to enlarge the lending resources of the rescue fund and enable it to buy existing debt? 

If implemented, this would do nothing fundamentally to address the unsustainable stock of debt and its adverse impact on growth, investment and employment. Instead, it would facilitate an even larger and quicker transfer of debt from the private sector to the public sector.

Rather than fantasise that a liquidity approach can overcome a solvency problem – and it will not – European officials should spend time discussing the cost of their “active inertia”. In doing so, they would quickly identify four issues that are further complicating the region’s debt crisis.

Continuing with an ineffective approach turns regularly scheduled bond auctions into dramas. It accelerates the private sector’s exit from peripheral debt markets, meaningfully limiting future demand. It pushes creditors to ask who is next, fuelling the migration of disruptive contagion up the European credit quality curve. It gradually weakens the integrity of the ECB and is likely to intensify the recent under-performance of German bonds.

More people are recognising that the time has come for another approach – what this week’s Economist magazine calls “Plan B”. This involves the orderly restructuring of some European sovereign debt on terms that allow a meaningful chance of re-accessing markets in future at sustainable rates. This would be accompanied by measures to enhance growth prospects in highly indebted European countries; ring fence the other, fundamentally sound economies; and push banks and other institutional holders of restructurable debt to raise prudential capital.

It is not easy to design such a plan. Nor is implementation success guaranteed. But this should not be used as an excuse to fixate on an approach that has repeatedly failed, and that will end up making Europe’s debt crisis even worse.

As noted in the column, this week the Economist Magazine concluded that it is time for Europe to turn to Plan B.

FOR a few weeks over the Christmas holidays, Europeans put their sovereign-debt crisis on hold. Now they are facing grim reality once more. Bond yields are spiking in an ever broader group of countries, just as the euro zone’s governments need to raise vast sums from the markets. On January 12th Portugal was forced to pay 6.7% for ten-year money—better than feared but a price it cannot afford for long. Yields for Belgian debt have jumped, as investors fret about its load of debt and lack of leadership. Spain is hanging on.

This mess leads to a depressing conclusion: Europe’s bail-out strategy, designed to calm financial markets and place a firewall between the euro zone’s periphery and its centre, is failing. Investors are becoming more, not less, nervous, and the crisis is spreading. Plan A, based on postponing the restructuring of Europe’s struggling countries, was worth trying: it has bought some time. But it is no longer working. Restructuring now is more clearly affordable than it was last year. It is also surely cheaper for everybody than it will be in a few years’ time. Hence the need for Plan B.

This bail-out strategy was a continuation of the bail-outs that have been used since the beginning of the credit crisis.  The party benefitting from the bail-out has always been the banks.  The party picking up the loss has always been the taxpayer.  The party in no-man's land is the investor as they expect that eventually they are going to get stuck for the losses that were initially the banks' and that the taxpayers do not want to cover.

The initial response, forged in the rescue of Greece in May 2010, has been undone by its own contradiction. Europe’s politicians have created a system for making loans to prevent illiquid governments from defaulting in the short term, while simultaneously making clear (at Germany’s insistence) that in the medium term insolvent countries should have their debts restructured. Unsure about who will eventually be deemed insolvent, investors are nervous—and costs have risen.

Naturally, investors do not want to buy existing losses.  Without the bail-outs, the losses would have been fallen to the equity and debt holders of the banks in 2008.  With the bail-outs, investors have to guess where the unrecognized losses are.  Are they still on bank balance sheets?  Have they all been moved to the sovereign debt markets?

The least-bad way to deal with this contradiction is to restructure the debt of plainly insolvent countries now. Based on this newspaper’s calculations (see article), that group should start with Greece and probably also include Portugal and Ireland. Spain has deep problems, but even with a big bank bail-out it should be able to keep its public debt at a sustainable level (see article). Italy and Belgium have high debt levels but more ample private savings, and their underlying budgets are closer to surplus. There is, thus, a reasonable chance that, handled correctly, euro-zone sovereign defaults could be limited to three small, peripheral economies.

Underlying the Economist's calculations are an assumption about the level of losses at the European banks.

The starting point for cleaning up the European banking systems and ending the sovereign debt crisis is to provide all market participants, including credit and equity market analysts and financial institution competitors, with asset-level information for each individual financial institution.  These market participants will independently evaluate the assets.  Based on this analysis, a market value can be determined for the assets in the banking system.  Using market values, market participants and regulators can determine how much, if any, additional capital each individual financial institution needs to be solvent.  This additional capital can be provided by the markets or the host sovereign.

Once the solvency status of a country's banks is known, it is straightforward to figure out what has to happen to the sovereign debt.

The perils of procrastination

This newspaper does not advocate the first rich-country sovereign defaults in half a century lightly. But the logic for taking action sooner rather than later is powerful. First, the only plausible long-term alternative to debt restructuring—permanent fiscal transfer from Europe’s richer core (read Germany)—seems to be a political non-starter. Some of Europe’s politicians favour closer fiscal union, including issuing euro bonds, but they are unlikely to accept budget transfers big enough to underwrite the peripheral economies’ entire debt stock.

Second, the dangers from debt restructuring have diminished even as the costs of delay are rising. Eight months ago, when euro-zone governments and the IMF joined forces to rescue Greece, their determination to avoid immediate restructuring made sense. There were reasonable fears that default could plunge Greece into chaos, precipitate bond crises in the euro zone and spark a European banking catastrophe.

But the European economy, as a whole, is now in better shape. Banks have had time to build up more capital—and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank. Greece and other peripherals have shown their mettle with austerity plans. Europe’s officials have created mechanisms to stump up rescue money quickly. And lawyers have been thinking about managing an “orderly” default. A sovereign restructuring could still spook financial markets—fear that it would spread panic makes Europe’s politicians shy away from it—but if handled correctly, it should not spawn Lehman-like chaos.

According to recently published reports, the ECB holds almost 20% of the outstanding sovereign debt of Ireland, Greece and Portugal.  The losses from any restructuring of this debt will probably require a recapitalization of the ECB.

At the same time the costs of buying time with loans have become painfully clear. The burden on the countries that have been rescued is enormous. Despite the toughest fiscal adjustment by any rich country since 1945, Greece’s debt burden will, on plausible assumptions, peak at 165% of GDP by 2014. The Irish will toil for years to service rescue loans that, at Europe’s insistence, pay off the bondholders of its defunct banks. At some point it will become politically impossible to demand more austerity to pay off foreigners.

As Ambrose Evans-Prichard observed, "banking busts are desperate, but not serious."  Unless of course the policies pursued by government officials transfer the losses to the sovereign through guarantees of the unsecured debt holders in the banking system.

And the longer a restructuring is put off, the more painful it will eventually be, both for any remaining bondholders and for taxpayers in the euro zone’s core. The rescues of Greece and Ireland have increased their overall debts while their private debts fall, so that a growing share will be owed to European governments. That means that the write-downs in any future restructuring will be bigger. By 2015, for instance, Greece could not reduce its debt to a sustainable level even if it wiped out the remaining private bondholders.

How to change course

A cost-benefit analysis, in short, argues in favour of carrying out an orderly restructuring now. The debt reduction should be big enough to put afflicted economies on a sustainable path. Greece may have to halve its debt burden. Ireland’s may need to be cut by up to a third, with some of this coming from writing down bank rather than sovereign debt.

All creditors, including governments and the European Central Bank, will have to chip in. New rescue money will also be needed: to fund defaulting countries’ budget deficits; to help recapitalise these countries’ local banks (which will suffer losses on their holdings of government bonds); and, if necessary, to recapitalise any hard-hit banks in Europe’s core economies. The ECB and others should stand ready to defend Belgium, Italy and Spain if need be.

If Europe’s leaders stick to plan A, the debt crisis will continue to deepen. If they get on with restructurings that are eventually inevitable, they have a fighting chance of putting the crisis behind them. Plan B will require deft technical management and political courage. Thanks to its emerging-market expertise, the IMF has some of the former. It is up to Europe’s politicians to find the latter.

As discussed above, the first requirement for successfully implementing Plan B is to provide all market participants with the asset-level information for each European financial institution.  This would allow the European officials to utilize the capital market's substantial analytic resources to determine who is solvent and who is not and how much capital is needed for the financial institutions that are not solvent.

What is under-estimated by European officials is the positive impact announcing the disclosure of asset-level information would have.  It would be a very strong signal to the capital markets that the EU is going to address and resolve the solvency issue once-and-for-all with the capital markets participating in the solution.

Absent the disclosure of asset-level information, any restructuring proposal is just government officials guessing and hoping that the capital markets like the results.