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.