Debt Buybacks and Backdoor Restructurings : Can Greece Pull an Ecuador ?

L’aide à la Grèce décidée par le sommet des chefs d’Etat e de gouvernement de la zone euro a de nombreux précédents en Amérique latine, écrit Eduardo Levy-Yeyati de l’institut Brookings à Washington, mais le plus proche est le cas de l’Equateur en 2008, le premier exemple de "défaut" provoqué non par l’incapacité à rembourser les dettes mais par la volonté de ne pas le faire. Mais le remède est illusoire. Seul un défaut en bonne et due forme peut appporter au pays concerné le sursis dont il a besoin.

The latest European package includes, as a way to lighten Greece´s heavy debt burden, a debt buyback : the European Financial Stability Facility (EFSF) would lend the money for Greece to buy back its own bonds in the secondary market at a discount, imposing a loss on private creditors while avoiding an outright default. There are, of course, Latin American precedents to this initiative : many casualty countries from the debt crises in the 80s conducted similar debt buybacks in the late 80s. Bolivia’s 1988 buyback of 46% of its defaulted sovereign debt, an operation funded by international donors, is a well researched example, which spanned a body of academic literature that concluded that, unless they were conditioned ex ante to significant concessions by participating debt holders, buyback would accrue mostly to creditors at the expense of the debtor –or, for that matter, the funding donors.

But the most relevant Latin American episode is more recent and less well known : Ecuador 2008, perhaps the first opportunistic default (that is, one triggered by unwillingness rather than inability to pay) in modern economic history. A widely foretold affair (debt repudiation was part of President Rafael Correa´s 2006 presidential platform), Ecuador used the default threat to depress bond prices in the secondary market, only to buy them back at bargain prices through the back door. The task was outsourced to Banco del Pacifico, which purchased the soon-to-be-defaulted Ecuadorian paper at prices above 20 cents on the dollar. When, after default was declared in December 2008, Ecuador launched an inverse auction for the defaulted papers, with the outstanding debt largely in friendly hands and the remaining bondholders forced to liquidate their positions to meet the massive post-Lehman Brothers withdrawals, the operation was a stunning success.

For the European case, Ecuador offers an obvious lesson : the crucial part played by the imminence of a default. Indeed, almost two years toying with the a potential default (which included a much publicized commission to evaluate the “legality” of the bonds, along the lines of the odious debt arguments) were not enough to induce a deep discount : Correa needed to move all the way to a credit event in December 2008 to purchase the bonds at fire sale prices. Panic (both due to Ecuador´s default and to the global crisis) was key for the success of the buyback.

Only a credible default ensures that the private sector takes a real hit. To see the “default matters” rule in practice, compare the market-friendly Uruguayan exchange in 2003 with the market-unfriendly Argentine restructuring in 2005. The first one reaped no nominal haircuts and only a minor debt relief ; the second, nominal haircuts above 50%.

Moreover, markets do not seem to matter. As early as in late 2006, right before the government intervened the Bureau of Statistics and started tampering with the CPI used to index a big chunk of sovereign debt (in what markets interpreted as a implicit default), Argentine spreads were close to those of Brazil. And even opportunistic Ecuador, blessed by the 2009 recovery in oil prices, could have returned to the voluntary markets shortly after the exchange.

The same default rule, incidentally, seems to apply to the voluntary private sector involvement embedded in the latest Greek package (if the commitment by 30 financial institutions listed in a recent IIF document eventually materializes), which would deliver a Brady-style exchange into 15 or 30 low-coupon par bonds (with principal guaranteed by AAA-EFSF paper) or high-coupon 20% discount bonds –offering a meager debt relief that nonetheless would trigger, as in 2001 in Argentina, a selective default rating.

All this begs the question : Can Greece pull an Ecuador, by convincing markets to sell their bonds at a loss for fear of a default ? Probably not. Because a credible offer from euro zone partners to fund the buyback of all Greek debt would eliminate the Greek premium (bailing out private investors in full), a buyback can only succeed (in the sense of sharing the losses with private creditors) if Greece can persuade the market that it is the last chance before a unilateral debt restructuring. In other words, from an ex ante perspective, a successful buyback can only be the preamble to default.

The underlying logic is simple. Small purchases at current panic prices are possible but remain a marginal effort that would not bring a substantive debt relief. By contrast, large purchases would drive secondary prices up making the whole operation unreasonably expensive. And the opaque Ecuadorian methods are out of the question, both because they are illegal and because a transaction of this size could be hardly disguised or outsourced.

Could the EFSF, instead, openly emulate Banco del Pacifico by funding the buyback of Greek paper up to a given threshold price ? Again, the perspective is not encouraging. If the threshold is set low to get a good discount, then the stock of debt retired would likely be small, as the buyback facility simply limits the downside risk while preserving the upside risk, thereby creating incentives to hold to the bonds (a perverse effect that could be mitigated by opening the facility for a limited time –although a promise of this kind would hardly be credible in the current context). By contrast, if the threshold is set high to bring bond prices to more civilized levels, purchases will be realized at moderate haircuts, getting dangerously closer to a bondholder bailout.

The premise that only a true default can bring true debt relief to a country remains unchallenged. Ultimately, it appears that only a euro zone rescue (through permanent cash transfers or financial risk sharing, as in a true fiscal union) could avoid a Greek default.