Managed defaults overseen by international bodies have been performed before in Uruguay and Argentina, with mixed success

James Meadway, Monday 10 October 2011 12.08 BST

After a year or more of denial, the inevitability of a Greek default seems finally to have been accepted across Europe. Successive bailouts have only postponed the reckoning. Substantial haircuts – losses to creditors – are mooted in official circles, with perhaps up to 50% of the debt being written off. The IMF has reportedly been pushing other international bodies to accept this.

With Greek sovereign debt approaching 189% of GDP, and the country plunging into deep recession, they have few other options. A terrible dynamic has been created. Mountainous debt, demanding repayments with interest, sucks resources away from real activity. As the economy shrinks, the real burden of debt increases, dragging the economy down further.

Default need not harm a country. Experience over the last decade, although not uniform, suggests the opposite: that by purging bad debt, an economy can clear the way to rapid recovery, however painful the initial shock.

A negotiated default could, in theory, drain the poison from the system. Greece could remain clamped to the austerity demanded by the IMF, EU and ECB “troika”, ensuring its remaining debt obligations would be met promptly. Meanwhile, a bloated European Financial Stability Facility, leveraged up to an eye-watering €2tn, could be used to calm panicked markets and assist stricken financial institutions. And the euro itself need no longer be under threat of disintegration.

Managed defaults, overseen by international institutions, have been performed before. Uruguay, like other South American economies, ran into its own debt crisis in 2003. A previous default by Russia in 1998 had frightened capital out of emerging markets. Devaluation by neighbouring Brazil in response had sharply worsened Uruguay’s terms of trade. Combined with sharp reductions in public spending, this provoked a severe recession by 2001. The uncovering of rampant bad practices in Uruguay’s financial system provoked a run on its banks early the following year. Its investment-grade credit rating was removed shortly after. By early 2003, Uruguay was unable to meet payments due to foreign creditors on its $10bn debt.

Uruguay was able, via a $1.5bn bridging loan from the US treasury, to open negotiations with its creditors, overseen by the IMF. A bond-swap was offered, replacing shorter-term bonds with longer maturities. Over 90% of bond-holders agreed to the terms and haircuts averaged only 13%. Uruguay’s downward spiral was broken, with four years of recession rebounding into growth of nearly 8% the following year and a similarly swift return to the international capital markets.

That is the happy template that Greece is being squeezed into. But Uruguay’s public debt at the time, while large, was approaching 100% of GDP – not pushing towards double that, as in Greece. It was not crippled by a fixed exchange rate regime, as Greece, trapped inside the euro, currently is. And it could rely, post default, on a booming world economy to drive domestic expansion.

Uruguay could afford a negotiated default. A small loss was sufficient to break the cycle of debt and decline, in benign economic conditions. Its creditors had little to complain about. Under the circumstances, they could take the hit.

But there is another, more ominous, South American example for troika officials to dwell upon. Argentina, too, entered into the same spiral of rising debt and shrinking economy after 1998. Under IMF tutelage, it also attempted a series of bond-swaps, rearranging the maturity dates on its existing debt to reduce the current burden. This culminated in June 2001′s “megaswap”, which rescheduled around $30bn of Argentina’s debt, pushing payments to beyond 2005. To secure the voluntary participation of Argentina’s many creditors in such a big operation, the terms had to be generous – so generous as to actually increase the value of Argentina’s debt. The debt dynamic was not broken. The economy disintegrated. Argentina defaulted, without agreement, on its entire $138bn external debt in December 2001.

Greece today is far closer to Argentina. Both are medium-sized economies. Both were trapped in fixed-currency regimes, preventing devaluation. And both stuck to IMF-led austerity programmes, backed up by debt restructuring. Just as in Argentina, the most recent attempt to voluntarily reschedule Greece’s debt, the much-heralded 21 July agreement, actually led to an increase in Greece’s real debt burden.

We are reaching the end of the line for voluntary, negotiated settlements. Even the 50% haircut now being floated may not be enough to break the spiral Greece is locked into. The worst of all worlds – of failed voluntary schemes, followed by unofficial default – could now be bearing down on the EU. Officials may want Uruguay. They could get Argentina.


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