What Europe's coming debt default will look like

I’m not sure why everyone thought comments the other day from the German Finance minister, Wolfgang Schäuble, to the effect that Greece may eventually face a sovereign debt restructuring, were such a revelation. This is in fact only a statement of the blindingly obvious, has been apparent in the market price of Greek sovereign debt for more than a year now, and was in any case implicit in the statement issued after the European Council meeting of March 24-25, when ministers said restructuring would be a pre-condition to borrowing from the European Stability Mechanism if debt was judged to be on an unsustainable path.
Even so, combined with the latest Moody’s downgrade on Friday of Irish sovereign debt, his comments have sparked a fresh round of jitters in markets, and led some commentators to think an act of default among the peripheral eurozone economies is imminent. I don’t doubt that certainly Greece, and possibly Ireland and Portugal will eventually have to restructure, but here’s why it’s not going to happen any time soon.
First and most important, none of these countries are yet willing to contemplate such a radical course of action. It’s possible that political developments in Europe could force such an outcome on them sooner rather than later; there is every chance, for instance, that Sunday’s election in Finland could produce a government hostile to any future bailouts, and therefore scupper the proposed Portugese rescue before it’s up and running. Things might quickly unravel if Finland refuses to take part in bailouts.
But assuming that doesn’t happen, it’s most unlikely that Greece, the most vulnerable of the four PIGS, would want voluntarily to restructure before the ESM comes into existence in 2013. That’s because it is neither in Greece’s interests to restructure before then, nor in any body else’s.
Greek banks are big holders of sovereign debt; a haircut of a third to a half would immediately trigger another banking crisis in Greece and turn an already catastrophic flight of capital into a rout. The banking system would very quickly collapse. A restructuring would also collapse the country’s pensions system, as the asset of choice among Greek pension schemes is Greek sovereign debt. Pensions too would have to be cut severely.
You can see why the Greeks are so determined not to restructure. Default would also require big write offs among German and other eurozone banks, and therefore necessitate a further round of recapitalisations. The systemic consequences would be extreme, possibly worse than the Lehman’s collapse. Much the same observations can be made about Ireland and Portugal. For any country, however small, default is a non trivial event. As David Owen of Jefferies puts it: “Even Greece is too big to fail”.
Yet by common agreement, Greece is already at the point of debt unsustainability; debts are so high that it’s going to prove not just difficult and painful, but virtually impossible to get them back onto a sustainable footing. The interest bill on the debt alone is just too big for the economy to be able to cope with. The point of unsustainability is generally acknowledged to be around 150pc of GDP. As you can see from the table below (click to enlarge), drawn from the IMF’s latest Fiscal Monitor, Greece is already at that point.

On the IMF’s projections, Ireland just about avoids it, though it wouldn’t require much in the way of a shortfall in growth to put the country in the same boat. Remember, if an economy contracts, its debt to GDP ratio will rise even if nominal debt remains the same. It was just such a possibility that caused Moody’s further to downgrade Irish debt on Friday. As Moody’s points out, last week’s hike in interest rates by the European Central Bank will further hinder the country’s return to growth.
On the IMF projections, Portugal is quite unlikely to get to the tipping point, while Spain is most unlikely to reach it. That doesn’t mean it won’t happen. These are only probabilities. By the way, you should ignore Japan, which dances to its own tune. That’s another blog entirely.
Now look at the second table below (again, click to enlarge), also drawn from the latest Fiscal Monitor. What this shows is the scale of the fiscal adjustment by way of tax rises and spending cuts needed to put public debt back on the path to 60pc of GDP, which was the pre-crisis average. What’s so interesting about these projections is that the biggest challenge by far, once age related spending over the next twenty years is taken into account, is faced not by Greece, Ireland or Portugal, but by the United States. I’ve written separately about the US debt crisis in my Friday column for The Daily Telegraph, which can be read by clicking here.

In any case, on the basis of these projections, you could argue that if Greece, Ireland and Portugal need to restructure, then so does the United States. The US, on the other hand, always has the backdoor default option of inflation, which it seems quite vigorously to be pursuing. That’s not open to the eurozone prisoners.
So not now for sovereign default, but maybe later, giving European banks time to prepare themselves for the losses. What form is that default going to take? Initially, it might be accomplished through what’s sometimes called a “soft default”, where debt maturities are extended and interest payments cut. But even that may not be sufficient. David Owen’s best guess is that the eventual haircut will be a third to a half of the principal. Not pretty.