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Why a Greek Haircut Is a Really Bad Idea

Lex Rieffel

Unlike the global financial crisis, the banking industry did not create the nightmare in Greece that is now playing out. The blame rests squarely on the governments of the European Union.

Yes, of course, the first party to blame is the government of Greece and the citizens who elected it. But if Greece were not a member of the European Union, and more narrowly the Eurozone, the problem would be much more manageable and the range of options far wider.

The grim reality is that the nightmare in Greece extends far beyond it. Mishandling the crisis can have a contagion effect on the rest of the European Union with a price tag substantially greater than the cost of a well-managed rescue operation.

A big part of the problem is that the EU treaty includes a “no bail-out clause.” While reasonable (although hotly debated) at the time the treaty was being negotiated, this clause is wildly unrealistic in today’s circumstances.

Germany’s thrifty and industrious citizens are justified in their anger about having to allocate some of their savings to rescue the underperforming Greek economy, but demanding the banks and investment funds that previously purchased Greek government bonds to take a haircut is foolish and short sighted.

Press reports that the German Social Democrats will vote for a financial commitment to a Greek rescue package only “if banks are made to participate.” A finance expert in the German Christian Democratic Union is quoted as saying that an international creditor conference will be necessary to solve the problem.

What these sentiments fail to recognize is the difference between a haircut and a rescheduling. A rescheduling of Greek debt could be done without generating brutal contagion, notably with respect to Portugal and Spain and Italy. In a rescheduling operation, debt maturing in the short term is converted into long-term debt with no loss of present value for the debt holders.

By contrast, imposing a haircut on banks lenders and bondholders means that the principal will be written down or the interest will be reduced below market rates, representing a substantial loss in present value.

Although it is a fine line between these two options, it is one that Germany would most likely regret crossing. It would represent a fundamental change in the unwritten rules of the international financial system. It would immediately undermine the value of sovereign debt.

To stress this point, it is helpful to recall Europe’s reaction to a series of balance of payments crises experienced by Turkey between 1959 and 1978. In brief, Turkey’s European, American, and other creditors agreed repeatedly to “reschedule” Turkey’s sovereign debt obligations. In each of these restructuring operations, even carried out initially within the OECD to avoid the stigma of rescheduling in the Paris Club, Turkey’s short-term obligations were transformed into long-term obligations with no loss in the present value.

Haircuts for banks did not become a feature of sovereign debt restructuring operations until Mexico’s “Brady Plan” deal at the end of the 1980s. There are two big differences between Mexico in 1987 and Greece in 2010. First, excessive bank lending was at the heart of the problem in Mexico—not in Greece. Second, Mexico was a developing country. In other words it was a high-risk sovereign borrower. Banks and bond investors were led to believe that the EU’s commitment to sound policies assured that lending to sovereign borrowers within the EU would remain low risk. The failure to maintain this degree of creditworthiness must be laid at the feet of the EU, not the private sector lenders and investors. Imposing haircuts, therefore, can be seen as making the private sector pay for the mistakes of the EU governments.

The political noise, especially from Germany, about how to address the Greek nightmare has seriously compounded the problem. It has sharply driven up spreads not only on Greek debt but sovereign debt across the EU. Who is profiting from this? In short, it is the banks that trade sovereign debt. They will earn rich fees as the spreads go up and be poised to earn more when the rescue package finally materializes and spreads start falling.

We have seen the populist power of the haircut argument in the United States. It peaked over the rescue operation for Mexico in December 1994, making it impossible for the U.S. government, and by extension the International Monetary Fund, to respond more than minimally to the Asian financial crises in 1997. A “symbolic” haircut of 5 percent, as some have suggested, will not stop the dam from bursting.

If the advocates of a haircut for Greece prevail, or Greece is unable to mount a credible adjustment program, then Greece will have to exit the Eurozone to limit broader damage to Europe and the global financial system. And the sooner the better.

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