The consequences of a possible default of Greece and other peripherals on the eurozone banking system have belatedly leapt to the attention of European governments. For this we can thank the near-collapse of Dexia. But this raises the critical question: How big will the Greek haircut be?

The question is not whether Greece will default; it is how big of a reduction in the present value of its debt will be imposed on creditors.

The restructuring plan

In July, the Institute of International Finance (the association of the largest international financial institutions) and the European Commission proposed a debt restructuring that aims at involving the private financial sector in burden sharing. The exchange aimed at mobilizing €54 billion from 2011 to 2014 and up to €135 billion in 2020. Participation was to be voluntary and involve 90% of the debt holders. The actual debt was to be swapped for four new bonds. The idea was to offer a menu of options in terms of maturity/yields/guarantees/face value, among which creditors would choose depending on their needs and time horizons.

• Two of the new bonds have the same face value as those they replace, but much longer maturities, 30 years, and much lower rates, between 4 and 5%.
• The other two, with maturities set at 30 and 15 years respectively, involve a discount on their face value, but have higher rates of return, between 6 and 6.8% in different years.

The first three types of new bonds incorporate a full warranty (the fourth bond only a partial one) on their nominal value. The Greek government would borrow from the European Financial Stability Facility (EFSF) and buy AAA securities, which would then be saved as collateral for the new bonds and placed in escrow.

An example

The main criticism of this proposed restructuring is that it is too generous to creditors and too costly for Greece. The guarantee would have the effect of increasing interest rates for new instruments, and would result in a haircut for creditors of only 21%. Regaining solvency would require Greece to reduce of its debt by at least twice as much–by up to 50% according to some observers. For example, even under the optimistic scenario where real interest were down to 4.5% after the exchange, and Greece were able to grow at 1.5% per year, a permanent primary surplus of 3% of GDP would be needed for Greece to stabilize its debt to 100% of GDP, given that the current debt is around 160%. That would require a ‘cut’ of 37.5% (= 60/160).

A few days ago, the German newspaper Bild reported that the German government has allocated €12 billion in the 2012 budget for a new rescue plan (the SoFFin) which should enable German banks to withstand a 50% haircut on Greek debt. The question is then whether Greece itself would find it convenient to force such a large haircut upon creditors.

The cost of large haircuts: New research

In a recent column on this site, Cruces and Trebesch present the findings of their study of 180 cases of sovereign default in 68 countries from 1970 to 2010. They calculate the haircuts associated with each episode (Cruces and Trebesch 2011). Unlike most of the previous literature which typically considers the consequences of default independent of the haircut size (e.g., Borensztein and Panizza 2008), the paper finds that the severity of default (that is, the haircut as a share of debt) determines how considerable the costs will be for the debtor country, both in terms of higher spreads after the restructuring, and in terms of a longer exclusion from international capital markets following the restructuring. The main findings are that an increase of about 20 percentage points in the cut is associated with:

• An average increase of 150 basis points in the spreads in the first year after the restructuring, and about 70 basis points after four to five years; and,
• A 50% reduction in the probability of new access to international loans in the years following the restructuring.

It is therefore reasonable to think that that the haircut implies a tradeoff between the immediate benefits from regained solvency and the longer-term cost/delay of accessing the capital markets in the future. Thus the haircut will be somewhere in between the 21% implied by the current proposals and the 40-50% required for solvency.

References:
Cruces, Juan J and C Trebesch (2011), “Haircuts and the cost of sovereign default,”  VoxEU.org. 13 October.
Borensztein, E and U Panizza (2008), “The Cost of Sovereign Default,” IMF Working Paper 08/238.