Ambrose-Evans-Pritchard at the Telegraph wrote about Portugal recently. It’s not a pretty story, but well worth reading. His conclusion is that Portugal will follow Ireland very soon. AEP ends his piece with:
Any better ideas out there?
I will give it a shot. But first let me say that I do not believe in plans that push problems down the road. I think we would all be better off to let nature rule on the economies. We have already had far too much intervention. Between bailouts, dangerous fiscal policies and downright whacky monetary policies it is hard to determine what is real in the global economy. A good chunk seems to be on permanent life support. That said:
To address the European sovereign debt problem a very big bazooka is required. It is a trillion dollar (equivalent) problem (including Spain, but excluding Italy). No one has that kind of money. For there to be a “solution” to the EU debt problems there has to be a new Brady Plan. It would require cooperation and involvement by all of the big global players including the IMF, Switzerland and China. It would require sacrifice by the countries affected; there would be costs to all EU countries. Lenders and bondholders would have to pay a price.
The Brady Plan relied on zero coupon bonds to securitize the principal of a sovereign borrowers debt. In 1989 Mexico restructured $50 billion of external debt. Holders got a new instrument in exchange for their un-payable old ones. The new bonds had an interest rate that was both favourable to Mexico, but still profitable to the banks (Libor + 13/16th or a fixed rate of 6.5%). The principal of the new bond was guaranteed by a 30 year zero coupon bond issued by the US Treasury. Over a short period of time Mexico’s problems went away and they prospered for many years (so did Brazil and a number of others). Mexico was no longer faced with any rollover risk. The principal had been defeased. They had a stable/predictable debt service cost of the old debt.
It is very hard to recreate the Brady Plan in 2011. The simple reason is that interest rates are too low and zero coupon securitization would cost too much. Outside of the market rate restriction there is the question of who would be the issuer of the new zeros? The USA is not the right answer this time.
In 1989 30-year interest rates were 9+%. Using the miracle of compound interest a 30-year Treasury zero cost only 9.5% of par. Mexico was able to secure the principal on $50b of debt at a cost of only $4.5 billion. Today that zero would cost closer to 30%. Two solutions. The zero must be 40 years and the implicit interest rate must be at 6%. The present value of that theoretical zero is $9.72 today. Using this number, $1 trillion of sovereign bonds could be secured with approximately $100b. That is progress.
Who would be an acceptable issuer to the marketplace of the zeros? My candidate is the IMF. The IMF would love to issue 40-year bonds at a fixed rate of interest, but they most certainly would not be willing to pay 6% to achieve it. A fair rate for this today would be 4.5% so there is a cost of 1.5% that has to be addressed. The cost in the first year comes to a manageable $1.5b (.01% of EU-GDP). But that miracle of compound interest works in reverse as well. Over the 40-year period it comes to a total of $81b. Who would pay this subsidy? In my opinion the cost should be allocated among the EU members. I propose that it be done annually, on pro-rata basis based on GDP. Yes, that implies that Germany and France would carry the heaviest weight. But they also have the most to win (and lose). Germany’s cost would be ~$500 mm in 2011, ~$30b over 40 years. What would the alternative cost? Many multiples.
The next hurdle: Assume that Greece, Ireland Portugal and Spain are in need of a $1T recap. Assume the percentages of that are Greece-10% Ireland 10% Portugal 5% Spain-75%. Assume finally that the cost of the zero is 10% of par. You get these capital requirements to initiate the restructuring:
These are daunting numbers. Coming up with this much money is essential to the transaction. This will prove to be the thorniest part of the “fix”.
Each of the countries has reserves that could be used to fund a portion of the capital required. For example, Spain has $25b of reserves available. Reserves are necessary for any country to manage liquidity. A trouble borrower like Spain must have adequate reserves, therefore the amount that each country could come up with is limited. However, post the proposed restructuring the countries will not have any maturities of debt. Their re-financing of future maturities will have been largely eliminated. Therefore they can manage with a lower net reserve position. I believe that each of the countries have the capacity to fund 10% of the required capital. That still leaves a very big hole.
$90b is not such a big number these days. This amount could come from the big surplus countries in the EU. The problem that I see is that this approach creates a political stumbling block. This money could also come from the IMF. But again, I am concerned with the optics of over reliance on the IMF. I would prefer to see that this money is raised from sources outside of the EU/IMF. My two candidates for this are Switzerland and China (the “S&C” loans).
Both countries have very deep pockets of reserves. Coming up with the $90b is not an issue. They both have big stakes in the outcome. Yet, selling this will be difficult. I point again to the fact that post a restructuring the credit profile of the countries will be dramatically improved. Their ability to service the S&C loans should not be in doubt. Therefore the loans are “money-good”. That said, it may be necessary for a broader EU guarantee on the S&C loans.
China would not want to do this. They have plenty of cash, but they may require trade concessions as an inducement. Should something like this happen China would ascend to the top of the list of global Kingmakers. This would blunt some of the criticism that they face on the currency issue. How much would they pay to buy some peace on this issue? Plenty.
Switzerland does not want to do this. Again, liquidity is not the issue; it is politics. In my opinion it is high time that Switzerland step up to the table. I do not want the Swiss (or the Chinese) to take risks on their reserves. I want them to use them to facilitate a broader solution. The Swiss have already spent massive amounts in an attempt to stop the CHF from appreciating against the Euro. If the EU blows up the CHF will soar. This outcome would be broadly negative to the Swiss economy.
I want another role for Switzerland. I want them to be the fiduciary that manages the financial paper work. There is no cost to this; they might even make a buck. Their role would go a long way toward giving the program the necessary respectability.
I feel very strongly that Switzerland must get involved and be part of a solution. They have had a free ride for a decade. It is now time for them to step up to the plate. If they resisted this responsibility I would like to see the EU retaliate with a broad increase in tariffs. A carrot and a stick.
Now the market side of this: I would propose that an exchange offer for new Capital Protected Bonds (“CPBs”) be voluntary. Most of the debt is held by banks. The fact that they would have no future capital risk would mean they could leave the bonds on the shelf forever and never face a write down. I would propose pricing on the CPBs to be close to that of Germany. That concessionary rate is justified as there is no principal risk.
If a holder of a sovereign Spanish bond chose not to participate in the restructuring they would not get paid cash at maturity. They would get a new 5-7 year bond (the “Exchange Bonds” or “EBs”) that have a yield set at EURBOR plus 1. There would be a market price for the EB paper. The holder of the original sovereign bond could sell the new EBs for cash. This would probably imply a loss. Tough luck. If they want to avoid a potential loss they have the alternative to participate in the CPBs.
This ties the knot on virtually all existing debt. Either it is rolled into the CPBs or it is exchanged for the new EBs. Functionally this has the effect of subordinating all of the existing debt. The countries involved will have “clean” balance sheets. They should be able to fund existing trade and current account imbalances from the market. Should that prove to be a trouble spot I would consider that there be EU guarantees on the new working capital debt. I do not think this step will be necessary.
The banks will hate this plan. I say, “tough luck”. They are collectively part of the problem and therefore should be part of the solution. There is a silver lining for the banks. The new securities (CPBs and EBs) will create a whole new trading opportunity for them. Give them something new to trade and they will shut up. I would not tolerate much opposition from the banks.
-This proposal avoids all losses to current holders of trouble sovereign debt. It restructures liabilities for many years. It could eliminate a substantial portion of the principal indebtedness of the borrowers. The portion that was not exchanged for CPBs would also be automatically pushed forward by a significant period of time. Debt service cost would be stabilised. Rollover risk will be eliminated.
-There is no incremental cost to the IMF.
-China and Switzerland have to step up to the global stage and play their role. They face little economic risk from this proposal, they would benefit from the stability/trade deals that would follow.
-The troubled borrowers would still have to face up to the need to reduce deficits. The amounts and pace of those adjustments will be less draconian than those that the IMF has currently required. While I doubt the countries involved would rejoice at this outcome it is far better than any other alternative they are currently facing.
-Note that there is no role for the USA in this proposal. Very deliberate by me. The US has no resources, no moral authority given its debt profile and its involvement would likely prove counter productive given the political gridlock that is soon to envelop D.C.