While we are waiting for the results of the stress tests, I thought I should quickly write about something else. After talking about the several debt restructuring options, I thought it would be interesing to consider debt repurchases in a world without (a Greek) sovereign default.
VOXEU has a new article on this where the authors argue that the solution is in debt buy backs, or debt repurchasing. This is interesting because back in March, VOXEU published another article arguing repurchases would only work in some conditions. At the time I wrote a little post on it, but I’m not quite sure I had understood what was going on. At the time, my conclusion, enlightened by that article and by this one from Manasse was that this was a fairly useless tool. I think that was a complete misunderstanding of my short review of the issue.
The conditions necessary for debt repurchases to work are not very restrictive. They are just difficult to discern ex-ante, because they are not environmental, but rather behavioural. As I understand it, if the sovereign wishes to fulfil its debt contract and pay back what it borrowed, then debt repurchases are good, because they would increase prices and thus decrease yields. Sufficiently high debt repurchases would therefore be a signal of the sovereign’s commitment to repaying its debt, and thus act as a provider of confidence. By creating more confidence it would thus decrease future costs of financing.
This logic clearly falls apart if default is the preferred option. Here’s what the authors say:
“For instance, for a government committed to honour its country’s obligations and invested in the policies needed to guarantee repayment the “true” value of the debt is close to its face value. However, the same debt can trade at a discount if the government is not be able to credibly convey its commitment and financial markets are sceptical that it will be able or willing to carry out its policy plans. Under these conditions, a buyback would achieve substantial savings. Further, it could act a signalling device and improve the country’s access to new external financing.”
“Buybacks may also appeal to governments that want to support their domestic creditors. Unlike for most Latin American countries in the late 1980s, in the current cases a significant share of sovereign debt is often held by residents (both banks and the non-financial private sector). Then, how the benefits from debt reduction are split between creditor and debtors becomes less relevant. In particular, for debt held by (possibly troubled) domestic banks, any transfer from the government may help reduce future recapitalisation expenses linked to public guarantees.”
“past buyback schemes have proven costly to debtors and typically resulted in large transfers of resources to the creditors, with little reduction in the net asset position of the sovereign. Indeed, after some such deals in the 1980s ”
“to the extent that the secondary market for debt is efficient and forward-looking, it is impossible for the debtor to purchase debt at the initial debt price”
“The debtor will only be better off if the total it spends on the debt buyback and the value of the remaining debt is less than the pre-debt buyback value”.
Therefore, to calm matters down, cash strapped countries (or the EFSF/ESM) should engage in large scale debt repurchasing as a signalling device (that they will fulfil their debt obligations) aimed at lowering future costs of borrowing.
The argument that the second article makes is that private involvement has been shown to be impossible and undesirable (I’m not sure, but reports today do seem to point towards that new paradigm), so that it is necessary to find an alternative. Debt buy-backs would be the solution. This would not be impossible from the point of view of EU law, specifically, its possible to find an appropriate reading of article 125 that allows debt buy backs from member states directly or indirectly through EFSF/ESM or EFSM. This is relevant because it is an issue that has been discussed for the ESM treaty.