IRISH WOES SHOULD SPEED EUROPE´S DEFAULT PLAN / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Irish woes should speed Europe’s default plan

By Nouriel Roubini

Published: November 15 2010 21:02

As the European Union attempts to force it to accept an aid package, Ireland’s government is close to being unable to sell its debt on the open market, a fate that befell Greece last spring. Bond spreads in Spain, Italy and Portugal are also rising, with the Portuguese finance minister warning on Monday that his country may have to accept a rescue package too.


In the short term the EU will kick the can down the road via a temporary Irish bail-out, just as it did with Greece. It is likely to do the same with Portugal. But it has finally dawned on the EU that a rolling process that places private bank losses on to public balance sheets could leave its governments insolvent too.


Put simply the Irish – like the Greeks – are on a path to near or complete insolvency. Their fiscal deficit will be 30 per cent of gross domestic product at the end of this year. Irish public debt will be 100 per cent of GDP at the same time, and is expected to reach at least 120 per cent in the next two years, possibly higher. Therefore there will soon need to be a public debt restructuring, regardless of the details of any temporary bail-out package. The important question facing EU policymakers is: how ought this restructuring be conducted?


So far the EU has justified emergency financing on the grounds that it lacks a formal legal mechanism to restructure debt. One such process under consideration by the EU, known as a “bail-in”, would see private sector holders of sovereign debt take losses before further government rescues took place. Indeed the recent blowout on Irish debt began just as it seemed that tentative EU agreement had been reached that a formal mechanism for restructuring sovereign debts needed to be introduced.


A similar debate occurred between 2001 and 2002, when the International Monetary Fund proposed a sovereign debt restructuring mechanism (SDRM) in insolvent emerging markets, to decide which debt holders were paid back and how much they would receive. But their experience showed that restructuring can occur using the traditional tool of a bond exchange offer, in which sovereign debt is exchanged for other assets.


Exchange offers implemented before a formal default were used as a way out of recent debt crises in Pakistan, Ukraine, Uruguay and the Dominican Republic. Argentina, Russia and Ecuador also used the technique, although each waited until after they had defaulted to make their offer. The EU should study these examples. If it did it would see that a formal legal mechanism is simply not necessary to implement the orderly restructuring Europe must soon introduce.


Those within the EU arguing for an SDRM worry about investors whose claims are close to maturity “rushing to the exits”, triggering a disorderly default and imposing greater losses on other creditors. Yet while SDRMs attempt to lock in investors’ claims, countries can stop debt holders rushing to the exits in other ways. They should also not worry about the problem of “free riders”, in which private investors let others accept an exchange offer, but refuse to do so themselves and wait to be paid in full at a later date. This risk is real, but the lesson of emerging market defaults was that only a small fraction of creditors risked free riding, if a reasonable offer was on the table.


SDRMs are also designed to prevent a “rush to the courthouse”, in which investors try to settle claims through legal means, post-default. But this is an unlikely scenario: the case of Argentina showed that sovereign immunity to prosecution is strong enough to prevent most claims. Also, while emerging market debt is usually issued in London or New York, most eurozone member debt is issued in their home capitals. Legal protection in Athens and Dublin will further reduce the chances of creditors having their day in court.


Of course even a defaulting debtor, like Ireland, will need to secure new financing to make the economic restructuring that goes along with the debt restructuring viable. But current IMF rules already allow this to happen, while the rules of the eurozone’s bail-out system, the €440bn European financial stability facility, could be extended to allow such financing.


Many of these issues can be avoided altogether if a eurozone member in distress conducted a pre-emptive pre-default exchange offer. This would avoid the need for the courts. The risk of systemic financial contagion would also be reduced: formal default is avoided, and losses to financial institutions that hold large amounts of sovereign debt can be postponed. Indeed, as Pakistan, Ukraine and Uruguay showed, a pre-emptive exchange can occur without reducing the face value of debt, either by extending the period in which it is due, or by capping the interest rate on new debt below market rates.


The current debate on a European SDRM is therefore a red herring. The reason the EU has so far decided to provide emergency financing to Greece and Ireland is not because it lacks a legal mechanism for orderly restructuring; it is rather because of concerns about systemic contagion. But an orderly restructuring via exchange offers is the best way to reduce this risk. The sooner the EU admits this, the sooner Europe can put its financial house back in order.


The writer is professor of economics at New York University, chairman of Roubini Global Economics and author of “Bailouts or Bail-Ins? Responding to Financial Crises in Emerging Markets”


Copyright The Financial Times Limited 2010.