Debt reduction without default?

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03 February 2011
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This paper proposes a two-step, market-based approach to debt reduction:

·         Step 1. The European Financial Stability Facility (EFSF) would offer holders of debt of the countries with an EFSF programme (probably Greece, Ireland and Portugal = GIP) an exchange into EFSF paper at the market price prior to their entry into an EFSF-funded programme. The offer would be valid for 90 days. Banks would be forced in the context of the ongoing stress tests to write down even their banking book and thus would have an incentive to accept the offer.
·         Step 2. Once the EFSF had acquired most of the GIP debt, it would assess debt sustainability country by country.
If the market price discount at which it acquired the bonds is enough to ensure sustainability, the EFSF will write down the nominal value of its claims to this amount, provided the country agrees to additional adjustment efforts (and, in some cases, asset sales).
If under a central scenario this discount is not enough to ensure sustainability, the EFSF might agree on a lower interest rate, but with GDP warrants to participate in the upside.
A key condition for this approach to succeed in restoring access to private capital markets is that the EFSF claims are not made senior to the remaining claims and the new private bondholders. EFSF support must be comparable to an injection of equity into the country.
While the EFSF concentrates on the exchange of the stock of bonds, the IMF could fund the remaining deficits in the usual way with bridge financing, until the fiscal adjustment is completed. The ECB would of course immediately stop its ‘Securities Market Programme’, which would have lost its raison d’être.
Daniel Gros is Director of the Centre for European Policy Studies. Thomas Mayer is Chief Economist with Deutsche Bank London.