Wednesday, February 25, 2015

Michael Pettis — When do we decide that Europe must restructure much of its debt?

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years. 

The history is, to me pretty convincing. Countries with this level of debt and this level of uncertainty associated with the resolution of the debt are never able too grow out of their debt burdens, no matter how determined and how forcefully they implement the “correct” set of orthodox reforms, until the debt is resolved and the costs assigned. Greece and Europe, in other words, have a choice. They can choose to restructure Greek debt explicitly, with substantial real debt forgiveness and with the costs optimally allocated in a way that maximizes value for all stakeholders, or Greece can continue to struggle for many more years as the debt is resolved implicitly, with the costs allocated as the outcome of an uncertain political struggle. 
Until one or the other outcome, the country is not a viable creditor and it will not grow. There is no way to get the numbers to work. If Europe policymakers who oppose a rapid resolution of its debt crisis continue to prove as intransigent over the next few months as they have been in the past week, I suspect that they will only be able to pull off one of their goals, which is to embarrass Syriza and get it thrown out of office. 
But I suspect that many European policymakers incorrectly think Syriza is as radical as it gets, and once Syriza is discredited, almost any alternative leadership would be better. I disagree. If Syriza is discredited, and the Greek economy continues to stagnate as I expect, the alternative could very easily be Golden Dawn or some other group of radical nationalists determined to blame foreigners for their problems, and Germany will have set itself up for much of the blame. It is ironic, because in my opinion Angela Merkel is not and has never been the bully that she is made out to be, and the main reason Germany seems to be running the show is that no one else has ever dared to disagree with her or to take any position of real leadership. For that reason she and Germany are being seen as far worse than they actually are. 
And this is clearly not just about Greece. Everyone understands that Greece has already restructured its debt once before and received partial forgiveness — in fact once coupon reductions are correctly accounted for Greece’s debt ratio is probably much lower than the roughly 180% of GDP the official numbers suggest. Most people also understand that the Greek debate is not just about Greece but also about whether or not several other countries — Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.…
What follows is a long and detailed analysis based on balance sheets.

  1. Why must Europe restructure much of its debt? The purpose of a debt restructuring is to make all parties better off by increasing the value of the associated instruments and improving future growth prospects for all the relevant stakeholders. Once the existing debt structure adversely affects future growth prospects and reduces the current wealth of the relevant stakeholders, it makes sense to consider ways in which the debt can be restructured so as to improve both current value and future growth prospects.
  2. For most economists, debt is the way operations are funded, and the best debt is the cheapest. I am not suggesting that economists are unaware that certain debt structures are riskier than others, but for the most part they ignore the structure of the balance sheet and focus primarily on the way assets are managed. The moment debt levels become high, however, or create institutional distortions, they begin to affect, and usually constrain, value creation. Debt has four very separate and very important functions, and it is important to understand what they are before deciding what an optimal balance sheet looks like.
  3. Once we understand the role and impact of the structure of the balance sheets, it becomes possible to describe what an optimal debt restructuring should accomplish.
Debt can be thought of as a moral obligation when a loan is extended from one individual to another, especially if there is no interest on the loan. But loans to businesses or to sovereign entities are business transactions, and they should be managed as such. The only moral obligation in restructuring sovereign debt, it seems to me, is for policymakers to fulfill their political responsibilities to do what is in the best interests of their citizens and to participate in a responsible way in the global community. The debt restructuring process is, in other words, morally neutral.…
"Excessive debt" begets uncertainty, which increases debt. When is debt "excessive"? When it begins to increase uncertainty to the level that the process is affected. Value begins to be lost, growth contracts, and existing debt multiplies.
To summarize:
  1. Under “normal” conditions, the obligations associated with debt are explicit and there is very little uncertainty about how the debt will be resolved. The revenues sources needed to service the debt are clearly identified.
  2. When debt levels become “excessive”, that is when the existing revenues sources are no longer sufficient easily to service the debt, uncertainty arises about how the debt will be resolved and even about the amount of the debt to be resolved. This is exacerbated by the highly reflexive relationship between rising uncertainty and rising debt, so that rising uncertainty associated with the resolution of the debt forces adverse stakeholder behavior, which causes the uncertainty associated with the resolution of the debt to rise further.
  3. How do we know when debt levels have become “excessive”? Debt levels are excessive when the uncertainty associated with the resolution of the debt is high enough to change the behavior of stakeholders. To put it in terms guaranteed to infuriate policymakers, a country has too much debt whenever the market believes it has too much debt. Anyone who does not understand why it is as simple as this does not understand the economic impact of debt.
  4. The purpose of a debt restructuring, then, is to reduce or eliminate the uncertainty associated with the resolution of the debt because this uncertainty automatically reduces value and future growth. If done correctly, a debt restructuring increases the wealth of stakeholders and improves future growth prospects.…
China Financial Markets
When do we decide that Europe must restructure much of its debt?
Michael Pettis | Professor of Finance at Peking University’s Guanghua School of Management

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