The inevitable is finally happening. Although new uncertainties tend to replace old ones -- the focus has shifted to Italy’s troubles in the past few weeks -- Greece is going through a default.
It’s likely that this process will be guided by the broad outlines of an agreement reached between the European Union and Greece in October, although the details are probably subject to change.
As part of that accord, Greece and its private creditors have been invited to implement a bond exchange with a nominal discount, or haircut, of 50 percent of face value. Even though acceptance of the invitation is portrayed as voluntary, this agreement is, in all but name, a default, and for practical purposes should be consider as such.
Many comparisons have been made between Greece and Argentina, and now that default will be another common feature, we believe there are two distinct -- often overlooked or misconstrued -- lessons from the Argentine precedent.
The first has to do with the timing and size of the debt exchange. In this regard, Argentina’s lessons are clear: Delaying the unavoidable and then defaulting belatedly, unilaterally and in a disorderly fashion, imposes significant costs in real activity, with no visible benefits. True, markets need to see some pain to be convinced of a country’s willingness to pay, in order to accept a default. But Argentina, like Greece now, went way beyond that. By the time Argentina defaulted in 2001, it had experienced four years of recession and its gross domestic product had declined by about 22 percent. How much pain should Greece endure?
On the size of the debt haircut, the conclusion is also unambiguous: If you have to cut, you better go for lock, stock and barrel. The key to restoring access to capital markets is to rebuild solvency based on debt sustainability after the restructuring. Returning to the financial market doesn’t depend on hard feelings about the size of the haircut. Argentina was initially regarded as a financial pariah because it refused to negotiate with bondholders. However, it regained access to credit markets relatively fast after the 2005 debt exchange, which entailed a very large haircut -- large enough to make the country solvent.
In financial markets, bygones are bygones and, once you have made the point that the default was inevitable, ex-post solvency counts for much more than manners, procedural details and how the haircut was achieved. It is in this context that one has to assess the reports that Greece is trying to extend the debt relief beyond the 50 percent haircut originally agreed upon. This is a correct approach because an insufficient discount will still carry the costs of a default without the benefits of a clean slate.
The claim that Argentina’s sovereign risk premium remained large throughout the 2000s is often posed as proof that the size of the haircut matters. But this overlooks the fact that by the end of 2006, a little more than a year after the completion of the exchange, Argentine bond spreads were almost equal to those of Brazil. They widened later for reasons unrelated to the default.
It follows from this experience that the faster Greece and its creditors stop haggling over the details, the sooner the country will be able to begin normalizing its relationship with capital markets.
The second lesson, equally critical, relates to the role of liquidity in a solvency crisis -- or who takes care of the casualties the day after default? The Greek saga has taken so long that debt restructuring is often seen as the endgame, whereas it is just the beginning. Judging from every emerging-market crisis in the 1990s (and most notably Argentina’s), one would expect the ongoing deposit run on Greek banks to intensify to the point of threatening the economic recovery. If not actively taken care of by the central bank, the deposit run and the resulting liquidity squeeze could easily compromise the payments system, paralyzing the economy in the aftermath of the default.
Ten years ago, when the run on Argentine banks deepened and the default was declared, both the need to ensure bank solvency through recapitalization and the provision of liquidity to the banks became critical elements to restore credibility. Back then, the bank-solvency problem was dealt with through “pesification,” a mandatory conversion into pesos of dollar deposits and loans that avoided huge bankruptcies. Most crucially, the central bank didn’t hesitate to print all the pesos needed to meet bank withdrawals. The run ended within six months.
In light of the Argentine experience, it seems of critical importance to assert unambiguously who will fulfill the role of a central bank in Greece, given that substituting the drachma for the euro may not be an option. Only a central bank can ensure that corporate solvency will be preserved and provide the liquidity needed to keep the economy running until confidence returns. It’s not clear whether the European Central Bank is ready to fulfill this role and to act as the European lender of last resort -- a role it has repeatedly rejected.
With this perspective in mind it may be useful to remember what the late Tommaso Padoa-Schioppa, formerly Italy’s finance minister and a director of the ECB, used to say: “A common currency is more than a common central bank: It requires a common political will.” But it is also useful to stress that the opposite is true as well: The political will to incur costs to buttress the common currency needs to be complemented with a central bank willing and able to act as a liquidity backstop once solvency is secured.
Only a combination of a prompt and bold restructuring and a fully committed and proactive central bank can put an end to the Greek ordeal.
(Mario I. Blejer is a former governor of Argentina’s central bank, was a senior adviser to the International Monetary Fund and is currently the vice chairman of Banco Hipotecario SA. Eduardo Levy-Yeyati, former chief economist of Argentina’s central bank, is a senior fellow at the Brookings Institution and a professor at Universidad Torcuato Di Tella. The opinions expressed are their own.)
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