*********#3. Removing Debt Overhangs **************
Crashing debt burdens don’t just frustrate the existing potential for economic dynamism today – they prevent new entrants from joining in with fresh capital that can act as oxygen for economic entities grasping for productive breath. Fresh air cannot cake a meaningful difference if it is immediately overwhelmed by what has become extremely stale and toxic air. In fact, if left to its own devices, the fresh air would choose not to come in and be contaminated!
On paper, there are four ways to overcome debt overhangs. The best is through high economic growth, which allows debtors to service and pay off existing debt while also maintain living standards and investing in their future. But now we do not have this option readily available. Instead, as illustrated by the extreme case of Greece, situations of excessive indebtedness can slowly slip into a vicious cycle in which inadequate growth aggravates debt overhangs, while at the same time the expanding overhangs themselves undermine growth further. To make things worse, the liquidity and solvency challenges become deeply intertwined and even harder to solve.
By taxing creditors and subsidizing debtors through artificially low and repressed interest rates, the financial repression regime that central banks have been imposing can help alleviate debt overhangs. But it takes a long time – a very long time – for such a strategy to make a decisive breakthrough. In the meantime, it risks significant collateral damage and unintended consequences that, among other things, distort growth engines, as we have discussed earlier.
A third way is through unilateral default. But this approach does not by any stretch of the imagination constitute a silver bullet. The inevitable disruptions and adverse consequences of unilateral default add to growth challenges in the short run, severely limiting access to credit and making it very expensive. It slows the reengagement of fresh capital and induces lenders to charge a much higher risk premium, at least initially. It can also encourage the sort of moral hazard that undermines responsible economic management over time.
All of this lead to the fourth way – that involving orderly debt and debt service reduction (DDSR). It is needed to overcome debt overhangs in situations where sufficient growth is not forthcoming, default would be too disruptive, and financial repression is not enough…. Taking experience from many years arranging both public and private financing to highly indebted Latin American countries, the international community came to realization that bolder steps to bite the bullet, such as engineering an orderly reduction in both debt and debt service, is needed so that new capital can sufficiently engage and restart.
Private sector component of excessive indebtedness could be handled through market based menu solution that reconciled the need to reduce the debt burden with some of the constrains that creditors had, be they accounting or regulatory. The DDSR design typically involved a menu of exchanges that grant present-value reductions to debtors while increasing creditors’ probability of repayment on the remaining (albeit reduced) contractual claim. They were enhanced where appropriate by various addendums, such as GDP warrants that made an incremental part of future debt servicing a function of how well the country recovers economically. The timely implementation is a lot trickier given the ability of a small set of creditors to hold up an overall agreement. Accordingly, recognizing the usefulness o orderly DDSR within the toolbox for crisis management and crisis prevention, officialdom has been working on ways to limit the ability of uncooperative minorities to unreasonably derail what the debtor and the majority of creditors are willing to agree to.
The public component of DDSR essentially involves debt forgiveness. A comprehensive approach Call “HIPC” Initiative, is used to reduce the debt burden of “highly-indebted poor countries” and simultaneously redirect resources toward growth, poverty alleviation, and the social sectors in those countries. This effort proved instrumental in unleashing the growth potential of several low-income countries in Africa.
Focus has shifted to “Debt sustainability analyses”, including how to overcome the legacy of persistent debt problems. Some of these involved large stocks of debt; others spoke to onerous terms, be they maturity, interest rates, or currency denomination. The result was a rich new analytical tool set that focused on the need to resolve the problem for excessive indebtedness that, almost irrespective of the reform efforts of the populations involved, made a return to financial viability and debt sustainability doubly hard – it imposed an excessive debt payment burden on the economy up front, and it discouraged new investment, which is the key to growth over time. Take the painful example of Greece, because they resisted outright debt reduction, fearing both the precedent and the popular reaction at home. As such, Greece continued to struggle under the stifling weight of a large debt overhang. And the problems became even more deeply and stubbornly entrenched, making the solution harder and more expensive.
In the situation of Eurozone, they remained too focused on cyclical solutions when the answer also involved structural and secular components. They avoided talking about debt reduction despite the fact that their emergency liquidity support to highly indebted countries was associated with growth rates that consistently under hot their own expectations, and projections. And they underestimated the societal and political implications of a prolonged period of economic underperformance and financial insecurity.
Because the advanced economies have not been able to also use other options, such as debt restructuring and conversions, which were used in the 1930s, – they have been undermined by a forgotten lesson. It is high time to change this.