Tackling the Greek debt problem, a look at the Latin American experience

The EU is promising a comprehensive proposal to tackle the Greek debt by the end of June.  If Greece were an isolated case, such a proposal would have been on the table a long time ago.  But it is not.  Portugal and Ireland are in similar dire straights, although for different reasons: Ireland was sunk by its banking sector and a speculative boom in construction, but at least it did produce rapid economic growth for a decade.  Portugal’s main problem, like Greece, is that its economy is not competitive and therefore stagnant.

What holds the EU back is how to reduce the Greek public debt, improve the prospects of the Greek economy without creating financial upheaval in the Union.  While the markets price a “haircut” of 40% to 50%, which would bring the debt back to 80% of GDP, this is not a viable option.  The reason is that a haircut that large is uncomfortably close to reneging on debt.

In 2005, Argentina could force a 70% haircut, on average, because its actions were an isolated case in Latin America and retail investors were significant holders of its debt.  Nevertheless, it has been blocked from issuing new bonds in the international markets ever since.  Furthermore, expectations from international investors were low to begin with.

But since European governments and institutions have been deeply involved in the Greek debt workout strategy, a 50% haircut by Greece would be viewed as bearing their stamp of approval (or demonstrating impotence, which would be worse).  As any credit trainee knows, credit risk depends on a debtor’s ability and willingness to pay.  Given the high participation of the Greek state in the economy and therefore the considerable assets it owns and could sell, a 50% haircut would be construed as an unwillingness to pay.

The fallouts would affect Ireland and Portugal, and likely extend to the whole Union except for Germany.  The status of the euro as a reserve currency would also be tarnished.  Therefore, unless the process veers out of control, this is not an option.

The most viable alternative is to maximize the sale of state assets, demonstrating the country’s willingness to pay within its means.  Any haircut, and there are valid arguments for a haircut of 15%-20% to spread the pain, would be to back-stop the assets sale/privatization efforts.  The assets sale is also more conducive to reactivating the economy than debt haircuts or excessive tax increases.

As I wrote in previous notes, there still will be the need to design strategies to make the Greek economy more competitive by identifying areas where it holds competitive advantages, but at least it would be from a stronger base, one where the private sector is a larger contributor and where the state demonstratively offers a stable legal and regulatory framework.  Chile in the 1980s rather than Argentina in the 2000s is the example to follow.

Tackling the Greek debt problem, a look at the Chilean experience (Part 2)

In my previous note, I recounted how a country like Chile in the 1980s had solved its external debt problem better and more durably than its peers.  Two key contributors to its success were voluntary debt swaps and well conceived privatizations.  The debt swaps permitted Chile to reduce its foreign commercial debt by one third.  It now seems that the privatization route is gaining advocates when dealing with Greece.

Today, Mr. Juergen Stark, a European Central Bank board member, stated that Greece could privatize over €300 billion of assets, far more than the €50 billion it has agreed to.  To put this number in perspective, let us remember that the Greek public debt amounts to some €320 billion.

It is my view that privatizations should be the main focus of the Greek rescue.  Doing so would reduce the need for ‘haircuts”, and benefit all parties involved.  There are compelling arguments to choose this strategy.

To begin with, it would be excessively difficult to convince creditors to forgive as much as 50% (the number most often quoted) of the debt of someone whose sellable assets equal such debt.  No bank would agree to do so for any of its corporate debtors, nor would anyone of us, individually or as tax-payers.

While it may appear tempting for a debtor to erase half of his debts, the cost of doing so is usually much higher than imagined.  In the 1980s, after years of muddling through, Latin American countries reduced their external debts by less than one third through the issuance of new (Brady) bonds (the effective haircut ended up being much lower that anticipated because of the secular drop in interest rates worldwide).  It took a decade before markets were willing to buy new Latin bonds at a reasonable premium over US treasuries.  Russia played hard ball, extracting a 55% haircut from the holders of its hybrid Soviet bonds (IAN, PRINs) but escaped durable punishment from investors by excluding its more recent sovereign bonds from any restructuring.  In 2005, Argentina stiffed bond investors with an average 70% haircut and has yet to return to the international bond market.

A 50% haircut would make it very difficult for Greece to regain access to the financial markets.  It would discredit it for years to come.  It would make tax collection and the collection of debts by the Greek state very difficult: after all, if the state does pay its debts, what authority does it have to convince its citizens to behave better?  It would also destabilize other sovereign European debtors by association so that support from the rest of the EU would not be likely.  Finally, it is worth remembering that negotiating a haircut with hedge funds and other non-bank creditors that have little if any long-term interests to protect will not be easy.

Assuming that Greece could durably service a debt amounting to 80% of its GDP, it would need to cut its debt down by half, or some €160 billion.  Assuming further that a 15-20% haircut would be viewed by markets as acceptable retribution for imprudent lending, Greece would need to privatize at least €100-€112 billion in state assets.  This is double what is currently under consideration but less than a third of what Mr. Juergen Stark considers the privatization capacity of Greece to be.  I think it would be a big mistake not to pursue the route of enhanced privatization.

Timing would be an important factor.  There are some assets, such as blocks of shares in well run companies, which can be sold now.  But the Chilean example shows very clearly that companies earmarked for privatization should first be brought back to financial health.  In the case of Greece, some labor laws also need to be revamped to allow for stronger economic growth.  Once these laws are enacted, the value of privatization candidates would appreciate greatly.  Subject to appropriate legislation, some state companies earmarked for privatization could be put in a trust for the benefit of the likes of the ECB and IMF; these institutions could then retire maturing Greek sovereign debt, having secured appropriate collateral with the assets held in trust.  Such a scheme would allow for the timely reduction of the Greek debt while allowing time for corporate remediation so to speak.  

As in the case of Chile three decades ago, the Greek government would be well advised to implement some sort of capitalismo popular so that the Greek people could participate in some key privatizations thanks to low interest bank loans.  It would be fair for them to participate in some upside since they will have to bear their share of the downside of the crisis.  It would also help sell a strategy of private ownership and free markets which is key for a real economic recovery. 

It is very much welcome that an ECB member is prodding all the interested parties to consider voluntary debt reduction via the sale of state assets as the principal avenue for sovereign debt reduction.  Hopefully, this will redirect and invigorate a debate which had stalled lately.

Tackling the Greek debt problem, a look at the Chilean experience

Greece continues to remain in limbo, with the ECB opposing a debt restructuring while some of the financially stronger European countries are favoring it.  The stumbling blocks seem to be fears of contagion, the impact on European banks, doubts as where Greek economic recovery would come from and implementation risks.  This reminds me of Latin America in the 1980s when policy makers were trying to pick to right time to devalue: the answer was, and remains, that such time doesn’t exist.

As decision makers dither, the financial conditions in Europe are only getting worse.  At prevailing yields, Greece couldn’t borrow long term if it wanted to.  The discount at which Greek debt is traded indicates that investors believe that a large “haircut” is inevitable.  We are fast approaching the moment when fears and rational expectations meet.

All parties would be well advised to consider the case of Chile in the 1980s, when that country was faced with massive financial and economic problems.  Not only did it solve them (without any help from multilateral agencies such as the MF or the World Bank or from the international banking community), it emerged, and remains to this day, the healthiest economy in the region.

The first element of the solution was to tackle the budget gap with old fashioned cost control.  As this was not sufficient, the government also embarked on a program of privatizations, with a twist. 

It is important to note that these privatizations were not rushed as the decision was made to bring the candidates back to financial health first.  This had several benefits: getting a higher price for these assets, establishing a good track record and winning lasting support for free markets from a large segment of the population.  Helping ordinary people become shareholders, often referred to as capitalismo popular, worked as follows.  Some of the largest state enterprises were sold to both strategic corporate investors and the public at large.  Because these enterprises had healthy finances, they could commit to pay substantial minimum dividends for a period of several years.  The public was offered low interest financing to buy into these privatizations, with the minimum dividends set at a level that was sufficient to pay the interest due on the financing and then some. 

To make significant reductions in the external debt, the government created two programs, one for existing foreign creditors (Chapter XIX) and another for Chilean residents (Chapter XVIII).  These programs allowed for the purchase of foreign debt at a discount.  Non-residents were allowed to remit the principal value of their investment after ten years.  Residents were not. 

If the external debt that was swapped for local pesos had been issued by the State, the discount was non-negotiable, otherwise it was up to the parties to negotiate it.  Typically, bank debt was swapped at a discount of around 25%.  As the program progressed, and the economy started to recover, the discount shrank.

   

To my knowledge, this swap program has been one of the most successful voluntary debt exchanges ever.  It helped reduced eligible foreign debt by US$ 7 billion out of a total of US$ 20 billion.  It helped local firms repay their external debts, and foreigners participate in privatizations or new projects.  It had two important corollary benefits: (1) rebuilding foreign investor confidence as the program was rigorously but fairly and consistently executed, and (2) serving as a crucial pump primer for new large strategic investments; large multinationals would often fund their initial capex using Chapter XIX rules and then follow up with entirely fresh foreign resources.  As a senior executive with a large US multinational at the time, I can testify as to how well this program worked.

None of these efforts would have brought about a lasting recovery unless Chile had been able to boost its exports.  I say exports because the Chilean population being small and not well off, it couldn’t offer a big enough market for above average economic growth.  Again, unlike many countries that had focused on import substitution, Chile took a strategic approach to exports by focusing on its comparative advantages.

It is ironic that ITT played a crucial, albeit indirect, role in this.  When it exited Chile, a small portion of its capital was unregistered with the Central Bank and therefore couldn’t be repatriated.  These were the days of capital controls.  ITT decided then to use these monies to seed what became the Fundacion Chile.

Over the years, Fundacion Chile acted as a catalyst in many of the important strategic development efforts of the country.  Besides acting as a think tank, the Fundacion educated would-be entrepreneurs and provide seed capital (literally).  The first major endeavor was the creation of a strong forestry sector.  This was followed by the creation of a fruit growing industry geared to exports which was fully operational by the mid-1980s.  The next major effort was the creation of the salmon farming industry. 

Each of these strategic projects was built on sustainable competitive advantages (fast growing pine trees, season inversion in the southern hemisphere and phytosanitary conditions provided by the Pacific and the Andes, cold pure waters of the southern Pacific); each developed into a multi-billion dollar industry.

Times are different, but Chile and Greece have much in common, such as small size, eccentric locations, excessive indebtedness, difficulties in obtaining outside financial assistance.

So the experience of Chile is very useful for solving Greece’s problems.  It shows that creditors will subscribe to a debt reduction program if it offers sufficient guarantees and has good chances of success.  It shows that governments must secure the backing of a large portion of the population by ensuring that both sacrifices and benefits are shared among all parties.  Finally, it shows that even a small country can find and exploit its competitive advantages.    

And the winner is ....

With the sudden resignation of Dominique Strauss-Kahn, the position of Managing Director of the IMF is up for grab.  Europe is insisting that tradition should be respected and that the new MD should be a European.  Emerging markets, buoyed by their relatively stronger economies, argue that the time has come for a change and that the job should be awarded to one of their nationals.   The US position, as stated by Secretary Geithner, is that the nomination process should be open and quick.  And the winner is…

Since its creation in 1946, the IMF has always been led by a European and since 1963, a Frenchman has led the institution 74% of the time.  The European exclusivity stemmed from an informal arrangement between the original great economic powers.  The French preeminence came from its greater political weight within the European Community, at least through the mid 1990s.

Today, Europe seems to advance the candidacy of French Finance Minister Christine Lagarde.  She is the best European candidate, has been an excellent FM, has an international work background and would be an excellent MD.  But should Europe lead the IMF now?

Those in favor argue as follows: first, Europe remains the second largest economic bloc in the world and as such deserves to maintain its influence over key international organizations such as the IMF; second, since the current flash points are Greece, Ireland and Portugal, an European MD would be best equipped to deal with the crucial cultural and political dimensions of any workable solution.

The other side argues that emerging markets are far more important to the world economy than they were in the 1940s and even 1980s, that they hold massive international foreign exchange reserves and therefore that their time has come to step up on the world scene. 

They also argue (more discretely) that Europe has managed its public finances very poorly so that it is hardly in a position to lead by example and be recognized, albeit indirectly, as the guardian of financial orthodoxy.  No doubt, many Asians remember the (in)famous photo of MD Camdessus standing over a sitting President Suharto signing a financial aid agreement with the IMF.

As the largest contributor of capital to the IMF, the US will likely play the role of referee.  So far, it gives the impression that while it would endorse Mme Lagarde, it is waiting to see if the emerging economies can rally quickly behind a strong candidate.  In the tug of war for the brass ring, Europe seems to have won the first round, and emerging markets are yet to put their demand into action.

As much as I respect FM Lagarde, I believe that it may be time for the right non-European candidate.  Why?

1-      There is no doubt that the most immediate sovereign debt problems have arisen in Europe and that the list of European countries in need of assistance may grow.  Individual merits aside, a European MD will likely be second-guessed and suspected of bias; less so a non-European MD;

2-      The need for cultural understanding and links to the European political power structure may be overstated given that both the European Central Bank and the European Commission would be parties to any and all individual rescues and would provided such “local link”;

3-      Non European countries may also need assistance, in which case the argument by some for having a European at the helm of the IMF disappears;

4-      Finally, a candidate MD with a successful track record of handling a deep sovereign debt crisis would enjoy greater expertise and authority than one without.  In that regard, France didn’t go through such a crisis so that Mme Lagarde didn’t either.

I can think of a few candidates who would meet the above criteria.  In the 1980s, Chile went through a wrenching debt crisis.  It dealt with it on its own, with innovating strategies and sound budgetary policies, without the benefit of multilateral help or the provision of fresh international loans.  It emerged as the healthiest Latin American country, to this day.  While Greece and others would be well advised to study the Chilean restructuring model, it is highly unlikely that any of the architects of the Chilean “miracle” would be nominated given their association with the then military regime.

On the other hand, Mr. Guillermo Ortiz, who as FM (1994-1998) orchestrated the recovery of Mexico from the 1994 debt crisis, would be an ideal candidate.  As FM he was both decisive, cool and very effective.  While the crisis couldn’t have been overcome without substantial help from the US, Mr. Ortiz was very effective in negotiating and coordinating the steps that led to eventual success.  Subsequently, as President of the Central Bank of Mexico (1998-2010), he consolidated the gains, stabilized the peso and contributed greatly to Mexico receiving an investment grade rating for its external debt.  As a Mexican, he comes from an economy big enough to give him credibility in the eyes of G7 countries; he also brings along the ability to work well with the US.

In the end, I feel that the decision will boil down to how fast the biggest emerging countries can line up behind a candidate of the stature of Mr. Ortiz.  If they do, he can and should be elected as the new managing director of the IMF.  If they can’t, Mme Lagarde will likely go through.  Either way, the world will be well served.