Coco for Europe

After a year and half of delay and denial, Greece is about to restructure its debts.

This, by itself, will not be enough to draw a line under the eurozone’s crisis. Greece will also have to downsize its public sector, reform tax administration, and take other steps to modernize its economy. Its European partners will have to build a firewall around Spain and Italy to prevent their debt markets and economies from being destabilized. Banks incurring balance-sheet damage will have to be recapitalized. The flaws in eurozone governance will have to be fixed.

The indispensible first step, however, is a deep write-down of Greek debt – to less than half its face value. The burden on the Greek taxpayer will be lightened, which is a prerequisite for reducing wages, pensions, and other costs, and thus is essential to the strategy of “internal devaluation” needed to restore Greek competitiveness. Forcing bondholders to accept a “haircut” on what they will be paid also promises to discourage reckless lending to eurozone sovereigns in the future.

Bringing us to the question of why it took policy makers a year and a half to get to this point.  The answer is that there are strong incentives to delay. The Greek government, for which restructuring is an admission of failure, continues to hope that good news will magically turn up. Likewise, French banks holding Greek bonds cling to whatever thin reed of optimism they can and lobby furiously against restructuring. European policymakers, for their part, worry that a sovereign-debt restructuring will damage the financial system and be a black mark for their monetary union.

The incentives to delay are myriad. The question is what can be done about them. Rather than resorting time after time to bailouts and delay, isn’t there a way to more swiftly and decisively restructure the debts of insolvent sovereigns?

One answer would be to add to future bond covenants contractual provisions that would trigger the necessary restructuring automatically. The concept is taken from the debate over bank reform, where there is an analogous problem of bailouts and bail-ins. Because of the difficulty of putting banks through a bankruptcy-like procedure, there is an incentive, like that which arises in the context of sovereign debt, to postpone the painful process of imposing losses on bondholders and instead provide a bailout and hope for the best.

Contingent convertible bonds, or “cocos,” have been proposed as a solution to this problem. When a bank’s capital falls below a pre-specified limit, its cocos automatically convert from debt to equity at a fraction of their previous price. This bails in the bondholders and helps to recapitalize the financial institution in question.

Extending this idea to sovereign debt, government bond covenants could stipulate that if a sovereign’s debt/GDP ratio exceeds a specified threshold, principal and interest payments to bondholders would be automatically reduced. The idea is that if there is no adequate incentive to restructure once a crisis starts, it should be built in before the fact.

“Sovereign cocos” have the advantage that their activation would not constitute a credit event triggering the credit-default swaps written on the bonds. The existence of large quantities of CDS, together with uncertainty about who has written them, has fed the reluctance to proceed with restructuring. Sovereign cocos would assuage the fear of creating an AIG-like event, in which a too-big-to-fail underwriter is over-exposed.

Objections to the idea start with the question of whether there would be adequate demand for these novel sovereign-debt instruments. In fact, the success of banks in issuing cocos suggests that investors do have the appetite for them.

There is also a concern that the government might manipulate the debt and GDP statistics on which the conversion trigger is based. Outsourcing these figures’ calculation to an independent entity, such as the International Monetary Fund, could solve this problem.

There would be worries that adding cocos to sovereign bonds might raise governments’ borrowing costs. But the literature on related instruments known as collective-action clauses suggests that borrowing costs would rise only for governments approaching the limit of their creditworthiness – that is, close to the cocos’ trigger. And raising borrowing costs for governments with dangerously heavy debts – thereby discouraging them from further borrowing – is precisely what we should want to do.

Adding cocos to government bonds will require solving a host of technical problems. But not adding them is a recipe for more delay, more bailouts, and more chaos the next time the debts of a sovereign like Greece become unsustainable.

Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley and the author of Exorbitant Privilege.

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