Some Thoughts On Potential Greek Debt Restructuring

By Win Thin

Here are some more thoughts regarding a possible Greek debt restructuring, which was reported today by the Greek press. Reports suggest that the EU, IMF, and the ECB have reached a basic understanding that a Greek debt restructuring is inevitable and that haircuts on principal as well as extensions of maturities to 30 years at lower interest rates (which in practice is a significant haircut as the Net Present Value of the debt will fall sharply) are being discussed. Of course, Greek officials have denied this, but official denials in Europe during the crisis have inevitably been superseded later by market developments and so have become pretty meaningless. There are also reports that Greece will be allowed to use EFSF funds to buy back its own debt. With Greek 10-year bonds trading around 73 cents on the dollar, this would in effect by a sizeable haircut for any bondholders that bought near par.

We have long felt that debt restructuring with substantial haircuts is the only viable solution to the current euro zone crisis, and so movement towards such an outcome is encouraging. We await further news of potential debt restructuring before getting more bullish on the euro since the pieces of the puzzle that would still be missing are 1) a comprehensive euro zone-wide debt restructuring plan and 2) structural economic reforms. With regards to 1), officials should know by know that efforts to ring-fence Greece are bound to fail and that a debt restructuring would not end with Greece. Ireland and Portugal (and perhaps others as well) must also be part of the debt restructuring plan in order for us to get more constructive on the euro zone crisis. With regards to 2), debt restructuring was only part of the success of the Brady Plan for Latin America. Just as important as debt restructuring were the IMF/World Bank-sponsored structural reforms that were instituted at the same time. Without those reforms, it could be argued that those EM debtors would simply have fallen back into the same debt trap if competitiveness was not addressed. Surely, it can be said that Greece (and others) will still be strait-jacketed by the single currency and that poor competitive positions will continue to be a drag unless structural labor reforms are seen.

Despite our skepticism on European policy-makers getting ahead of the curve, the Greece story does fit into the recent narrative that euro zone policy-makers are finally getting serious about tackling this crisis rather than just kicking the can down the road further. Peripheral spreads to Germany are largely narrower today after widening late last week. Firm peripheral bond prices earlier in the week allowed the ECB to halt its bond purchases last week for the first time since late October. We note that if and when the eventual debt restructuring comes, having Greek, Irish, and Portuguese debt in the hands of the ECB should help the process along, as the debt is being held by strong hands instead of weak. The other factor helping to support the euro recently is the widening of interest rate differentials, which today took on another leg higher after higher than expected euro zone inflation was reported for January. The 2-year US-German differential is now at 85 bp, the highest since January 2009. Note that the euro is looking to test the 1.3750 area, which is the 62% retracement level of the November-January drop in EUR/USD. Market tested that level last week and failed, but a break would signal deeper USD losses.

5-Year CDS

2-Year Spread to Bunds

5-Year Spread to Bunds

10-Year Spread to Bunds

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