MercoPress. South Atlantic News Agency

The Uruguayan 2003 controlled default model, a way out for Greece?

The Uruguayan default model of 2003, under the auspices of the IMF, is a possible way out for the Greek situation according to Professor Reinhart (*), a world authority in sovereign defaults. The idea surfaced in an interview with the Telegraph.co.uk, Ambrose Evans-Pritchard who has covered world politics and economics for 25 years, based in Europe, the US, and Latin America.

Professor Reinhart argues Greece cannot hope to escape from its debt trap under the current EU austerity plan. The cure of devaluation is blocked by the Economic and Monetary Unit EMU membership and a restrictive monetary policy of the European Central Bank — a contraction of both M3 money and lending to firms with record low core inflation — “must inevitably unleash deflationary forces in Mediterranean states already trapped in credit busts.

A country can in theory deflate its way back to competitiveness by an “internal devaluation”, for example relative wage cuts, in this case by 20% to 25%.

Benito Mussolini cut wages by 20% so in 1928 when Italy returned to the Gold standard with his Lira Forte policy, but he had “Fascist controls on the unions, and ‘Black Shirts’ to assist and in any case Italy was not facing the aftermath of a property boom.

Reinhart says it may not be possible for a country to execute such a policy when it already has a public debt above 100% of GDP, or in Greece’s case nearing 130% by next year. Debt dynamics take over. The policy leads to a self-feeding spiral in compound interest. This will become evident very soon if — as some economists predict — Greece’s economy contracts by 4% to 5% this year.

Ireland is experimenting with this cure. We are seeing the consequences. Nominal GDP has fallen 18.7% since the top of the boom, according to Barclays Capital. Real GDP has fallen by less, 12.6%. The rest is the effect of deflation. But what matters most for debt is nominal GDP. The same debt load has to be financed from a nominal economy that has shrunk by almost a fifth. That is why deflation can be so deadly, as it was from 1930-1933.

It is no surprise that the losses of the Irish banks are now proving catastrophic: they cannot be isolated from the Irish state. Ireland is now at a risk of debt spiral. The budget deficit was 11.7% of GDP last year, despite spending cuts. Irish GDP fell a further 2.3% in the 4th quarter. There is no longer any low-lying fruit for the tax authorities. Further austerity would cut deep into the muscle and bone of the Irish welfare system.

Ireland may yet recover. It has a vibrant export base and a very flexible economy. Leadership has been superb. The plan is at least “doable”, although a weak sterling next door makes the task that much harder.

But Greece is another story. It did not invest its EU and EMU windfalls in a well-educated workforce and high-tech enterprise. It spent the money on public payrolls – and submarines — and cut the retirement age as low as 54 for some. We will find out whether it has now gone beyond the point of no return.

Professor Reinhart said Europe will have to bite the bullet and accept `debt-restructuring’ or grapple with unending disaster. Since Germany obviously will not agree to provide the massive long-term finance at cheap rates needed to nurse Greece through the crisis – let alone direct subsidies – there is no alternative: lenders must agree to stretch maturities on Greek debt, and accept an interest rate haircut.

“I don’t think the markets have yet understood this” according to Prof Reinhart.

She said the model is the Uruguay controlled default in 2003, conducted under the auspices of the International Monetary Fund when she was working at the Fund.

“Everybody got together in a civilized way, and it was very successful,” she said.

The average haircut was 13%. Maturities were shuffled. Uruguay was praised all round.

Greece is a tougher nut to crack. French banks with €80bn and German banks with €40bn (and British banks too) that bought so much Greek debt at a few basis points over German Bunds in 2006 and 2007 will have to accept a bigger discount to atone for their epic error, perhaps 25%, though Prof Reinhart did not put a figure on it.

It was always obvious that Greek bonds was not equivalent to German bonds, and that country in a currency union running a current account deficit of 15% of GDP was trouble waiting to happen. Creditors bought the debt on the basis of a political calculation that EMU would bail out Greece if necessary. It was pure moral hazard.

This “pre-emptive restructuring”, in IMF lingo, has to be handled with care. “When people say there is no contagion risk because Greece is small, they are completely wrong. Thailand was a lot smaller in 1997, and look what happened.” Indeed, it set off the Asian financial crisis.

A Greek default would be twice the size of the two largest defaults in history put together — Argentina and Russia — at least in nominal terms, nearing €300 billion. The “demonstration effect” in a long string of countries both inside and beyond EMU might be chilling.

In Uruguay’s case it took the recognition that the country was trapped in an untenable situation after Argentina defaulted next door and devalued by two-thirds.

(On 28 May 2003, Uruguay successfully finalized a voluntary debt exchange with the private creditor community. The exchange provided annual debt relief equivalent to approximately 5% of GDP from 2003-2008, and established that no bonds would mature until 2008).

But is anybody in a position of power in Europe yet willing to contemplate such a solution for Greece? Is France? Germany? European Commission? Or is the ruling machinery of EMU so twisted in ideological knots, and prey to conflicting national agendas, that nothing can be done beyond staging empty summits in Brussels that gain less and less market traction each time? This last deal has been tested within days. Greek spreads are through the roof again.

In my view, the IMF should not agree to take part in a joint rescue with the EU unless it calls the shots. It should take charge and impose a Uruguay solution. If the Europeans demur — as they surely will — it should make it clear that creditors from the US, China, Japan, Canada, Saudi Arabia, et al, will not waste their IMF money prolonging a dysfunctional foolery by EU institutions. It should walk away, and slam the door.

On a parting note, Professor Reinhart says the only budget deficit that matters in a crisis is the “cash deficit”, and this reached 16% of GDP in Greece last year — not the 12.7% officially registered under “accrual” accounting.

As countries near default, they typically find all kinds of way to disguise their troubles, by shifting debts between government agencies and delaying payments.

“In the end, everything comes out of the woodwork. You realize that it is even worse than you thought,” she said.
 

(*) Professor Carmen Reinhart is author of “This time is different: eight centuries of financial folly”. During the interview with Ambrose Evans-Pritchard, Professor Reinhart was wearing a medallion of a Spanish silver coin dating from 1580, celebrating Philip II’s third default in eighteen years.

These magnificent defaults did not stop Spain launching the Armada against Elizabethan England a little later, or attempting to roll back the Protestant Reformation in a last maniacal attempt to impose Habsburg-Papal absolutism on free thinkers, but it did cripple some great European banking dynasties — about 20 in all.

The Fuggers bit the dust. They were the richest family in Christendom in the 16th Century and bankers to the Counter-Reformation, the Citigroup of their day. This cleared the way for rise of Dutch and Anglo-Scottish finance, and the great power shif to the North Atlantic.