Big sovereign debt exchanges have been a long time coming in the Eurozone. Firm statements against any haircuts for Greek sovereign debt gradually gave way to a voluntary, bank-led agreement for a 21% reduction in net present value. But from there, it became obvious that 50%-60% would be a more realistic haircut.
At the time of writing, this was what was on the table, although the details of the debt exchange offer were still being stitched together. As yet there are no suggestions of similar schemes elsewhere. But although Greece is the most obvious candidate for a debt restructuring, markets are looking ever more closely at the debt mechanics of all European sovereign borrowers.
"Looking at debt sustainability a countrys ability to raise cash and pay its debts over time is relatively new from a European sovereign standpoint," says Christopher Drennen, head of strategic marketing at BNP Paribas.
"Over the last year, the idea of applying basic corporate cashflow models to European sovereigns has gained traction, because a debt to GDP ratio is too simplistic for members of a monetary union. A cashflow model in a basic form can be simple if you have to pay 120 next year and your income is 100, then theres a problem."
As investors think twice about investing in European sovereign paper sending yields sharply north talk of debt exchanges has grown louder. But in some guises these operations are not new, even for Europes sovereigns.
There are many ways of describing offers to exchange debt or tender it for cash from the commonplace liability management to the fear-inspiring debt restructuring. Newly fashionable terms like debt reprofiling float somewhere in between, although are typically euphemisms for something unpleasant.
This variety reflects the many forms that these exercises can take. Sovereign debt specialists and liability management practitioners are quick to highlight that many developed market treasuries regularly use these operations to manage their maturity profile. At the simplest end of the scale, many buy back short term paper in the secondary market and issue longer dated paper.
"In the larger economies, such as the US or the UK, the sovereign is undertaking exercises on a daily basis through the market on their own debt," says Andrew Burton, head of liability management at the Royal Bank of Scotland. "Liability management is commonly understood in the context of public exchanges or tender offers, but thats just one tool available. All of the more sophisticated DMOs manage their debt profile through open market operations."
Not everyone has this option, though. Some sovereign borrowers, typically in emerging markets, lack the secondary market liquidity needed to buy sufficient quantities of short dated paper in the open market. This is where public tender or exchange offers enter the frame.
One standout user of these tactics is the Philippines. In a bid to stretch out its maturity curve, the borrower has been an active user of exchanges and buybacks.Last December, for example, the country offered to exchange bonds with up to nine years left to run for a new 10 year or a new 25 year issue. Separately bonds maturing between 2020 and 2034 were eligible for exchange into the 25 year, and the offer included a cash tender and new cash elements. Investors tendered some Ps232bn (3.9bn) of paper for the two exchanges (see graph).
Andrew Montgomery, head of liability management for EMEA at HSBC, says the timing and structure of the Philippines liability management operations strengthened the perception of the borrower in the market.
"The Philippines has done four large scale exchanges over the last 18 months," he says. "Despite the scale, theyve had a very clear, rational objective that the market has bought into and theyve benefited from. Theyve improved their standing in the international investor community, rather than calling into question their ability to fund."
Reading the market
The strategy worked for the Philippines, but stepping out with liability management transactions can go the other way. It is all a matter of signalling. With market access based on confidence, it can sometimes be difficult for a sovereign to paint a large buyback or exchange exercise as a tactical move, rather than a reflection of more fundamental issues, says Montgomery.
"LM tends to work very well when you are doing very well, your credit is good, and you have access to the new issue market anyway," he says. "And it works well at the opposite end of the scale also, when an issuer truly is distressed and capital markets restructuring needs to take place, as was the case for Uruguay and is the case for Greece.
"But its when youre in the middle and trying to potentially undertake a large scale transaction, that it could raise questions around potentially being able to fund."
Two factors are critical for big sovereign debt exchanges to work: timing, and presenting a credible story to investors.
Italy is a good example of the first. Bond yields have rocketed this year in a reflection of investors sudden worries about the countrys debt sustainability even though locals would argue that little in Italys debt metrics has changed drastically. But now that investors are sensitised to the countrys debt metrics, if the sovereign were to go ahead today with even the most benign of public operations to, say, lengthen its maturity profile, it could be interpreted as an indicator of trouble.
"It matters a great deal when you do these operations," says Harvinder Sian, RBSs chief European strategist. "For Italy to go now, given the distress in the market for its debt, it would be damaging from an investor perception. If they were to extend their debt, the market would assume there are problems out there."
A strong recovery story is the other important factor for ensuring the success of a big liability management exercise. Investors will have little interest in participating in a voluntary exercise if they fear that heavier haircuts, or even all-out default, may follow later down the track.
"For a distressed country, a liability management exercise will only be successful if it is part of broad support package it cannot be taken in isolation," says Christian Fringhian, head of public sector solutions at Barclays Capital. "That support package needs to include measures to stabilise and turn around the economy, maintain stability in the banking sector and prevent contagion, and finally regain debt sustainability. A liability management exercise must sit within this framework to be successful, to create confidence and trust in the sovereign and remove anything that can bring anxiety about sovereign credit."
This is likely to be a critical factor for the Greek private sector involvement (PSI) exercise, where there are obvious worries about the future financial position. Official estimates on growth in Greece vary markedly from private sector calculations.
Official figures suggest Greece will bring debt down to 120% of GDP by 2020 through the exchange and a package of other reforms. JP Morgan economists, who use less optimistic assumptions, say Greeces debt might ultimately stabilise at around 190% of GDP. Moodys also says the 120% debt to GDP ratio could be difficult to meet by 2020 given the "formidable" challenges facing the nation. In particular, the ratings agency has concerns over Greeces growth rate, the 50bn privatisation plan, which it terms "ambitious", and the countrys ability to execute the economic and fiscal reforms which are part of the package.
Learning from LatAm
Specialists in liability management often point to Uruguays debt exchange in 2003 as a textbook case of how to restructure sovereign debt in a way that alleviates the payments burden but leaves investors more or less happy. Uruguays example also runs in stark contrast to its larger neighbour Argentina, which has spent years arguing with holdouts over a messy debt restructuring that began in 2001.
Hit by a series of sudden external shocks and a banking crisis, Uruguay floated its currency in 2002. The country, which until then had been a model emerging market borrower, quickly entered a situation where it struggled to service its debt. This is where the exchange offer came in. The exercise was designed to lengthen the maturity profile, to give the borrower breathing room as it dealt with the shocks and returned the economy to growth.
Calculations vary over the haircut imposed by the offer, but Federico Sturzenegger and Jeromin Zettelmeyer calculated in a July 2005 IMF working paper that it averaged around 13%. That made it a lot more bondholder-friendly than the haircuts Argentina offered in its 2005 exchange, which Sturzenegger and Zettelmeyer calculated at around 74%. Uruguay was able to sell the offer as part of a recovery story: the exchange would set it back on a path to growth and debt sustainability.
It worked for Uruguay: more than 90% of investors bought into the story and accepted the haircut. The country moved on.
But each countrys own circumstances are unique and its fanciful to think that Greece could take tips from Uruguay and have investors smiling again in short order.
The differing debt metrics are obvious. Greeces debt to GDP ratio topped 140% last year. Ahead of its own exchange, Uruguays was around 111%. Uruguay said that the package around its exchange would set the country on a path to reducing debt to 55% of GDP within a decade.
Greeces debt burden makes it difficult to strike a balance between keeping investors onside and bringing liabilities down to a sustainable level. In a situation where investors would take a 50% haircut, a very high participation rate would be needed to make the deal work.
"From an investor perspective, whether holders participate is going to be dictated by the marks and accounting treatment they give them," says RBSs Sian. "But they need to have close to 100% participation, given the numbers. The research view here is that will be difficult to achieve. They were struggling to get to 90% with a 21% haircut under discussion a 50% NPV loss will put some holders off. And then you have to question whether this will be the last PSI. The market is concerned about a harder default to come."
JP Morgan analysts also say that another round of PSI may be ahead. But they say the threat of more coercive treatment of holdouts in any future private sector burden sharing initiatives could drive participation in the current exercise.
If the numerical differences were not enough, there are other important differences between the situations of Greece and Uruguay going into debt exchanges. A monetary union that brings with it unique complications for Greeces debt management operations is one example. According to economists at Capital Economics, Greece would struggle to become competitive while inside the monetary union without "massive" internal devaluation.
"One thing thats unusual about the process is that its bounded by a political perimeter from the start," says Christopher Marks, global head of DCM at BNP Paribas. "Greece is unlike any other sovereign liability management transaction. It sits within a monetary union, and that monetary union is under considerable scrutiny.
"At the beginning, with the July 21 agreement in what was a very consensual arrangement, it was very clear that it was done to facilitate a quick, acceptable solution. As conditions have worsened, weve moved towards a much harder, but open eyed, practical, solution, but again it was based on consensual agreement."
The other defining factor in the Greek situation is the number of political actors involved in the debt talks. "In the LatAm exercises, the IMF was a dictating force," says RBSs Sian. "Here the IMF is taking a secondary role, and the process is at the whim of politicians negotiating a politically viable solution. So, with regards to Greek PSI, it is a bit more destabilising for the market than it might otherwise be. If youre even beginning to consider the large countries, like Spain and Italy, there are global ramifications, which wasnt the case with Uruguay. These countries are far more globally systemic."
Given the number of players involved in discussions around the sovereign debt crisis, communication so far has been impressive, reckons BarCaps Fringhian.
"There have been a few snafus, like Finlands request for collateral, but thats unavoidable when you have so many countries that have to approve a single policy," he says. "So far the EU has been proactive in finding solutions. As market participants, we need to give credit to whats being done at the political level. Its not easy. The euro is still a very new currency."
As the cacophony of different interests pushing for their best outcome in the sovereign debt crisis drives the changing stance, one element of the exchange seems immovable: it will be voluntary.Several reasons lie behind this. One is that triggering credit default swaps appears to be a can of worms that no-one is inclined to open although it remains unclear why this should be the case or who precisely is driving the desire to avoid a trigger (see separate chapter on page 44). Another is that, despite European politicians assurances that Greece is a unique case, the exercise is being scrutinised as a test operation for other countries. If Greece forces haircuts on bondholders, fears will rise that a similar move could happen in other jurisdictions and the markets will respond appropriately.
Gary Jenkins, head of fixed income at Evolution Securities, also points out that a disorderly default, where all lenders have to take write-downs, would be politically unpalatable for the EU and ECB, which have lent Greece 87bn through bilateral loans and bond purchases over the last 18 months alone.
"As with any liability management transaction, it has to be based on an assumption that its anchored in an agreement between entities holding the paper and the entity doing the exercise, i.e. of a voluntary character," says BNP Paribas Marks. "Thats the starting point. Not because its a matter of treating investors nicely, but because no matter how you describe the exercise as debt stock reduction or an amelioration of cashflow, you have to get a large number of people into the trade for it to be relevant."As the European sovereign debt crisis worsens and the euro currency approaches a make-or-break moment, the flexibility offered by successful liability management looks crucial for the future. On their own, debt exchanges cannot solve the problems. But they will help.