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During a country’s financial crisis and the possibility of default, there are often exaggerated warnings of long-term financial ruin. Bondholders, especially, express their concern when a country appears to be considering a significant restructuring. They protest that the country will be unable to access the bond market for a very long time. However, a recently published paper by Patrick Bolton, Xuewen Fu, Mitu Gulati, and Ugo Panizza challenges these warnings and reminds us that countries should not necessarily pay heed to them.
In 2012, Greece was able to successfully execute the largest sovereign debt restructuring in the world, thanks to its utilization of its bonds issued under local law rather than in New York or London. This gave Greece the power to amend its bonds unilaterally through legislation. Instead of directly reducing the bond values, which would have been considered aggressive, Greece introduced “collective action clauses” that bound all the creditors to a restructuring agreement approved by a large majority. This allowed Greece to coercively implement a voluntary but rigorous restructuring that applied to all local-law-bond creditors, mostly European banks.
These actions received significant criticism and pessimistic predictions from investors at that time. Bill Gross of Pacific Investment Management Co. stated that Greece’s debt swap had diminished the sanctity of bondholders’ contracts. David Kotok of Cumberland believed that Greece’s actions would create a risk premium in the European sovereign debt market. The retroactive nature of Greece’s legislation was seen as a violation of the rule of law by Lachlan Burn, a lawyer at Linklaters.
Nevertheless, the long-term impact of Greece’s debt restructuring disproved many of these concerns. The paper’s authors conducted an in-depth analysis of bonds issued by different countries under different jurisdictions and observed their reactions to various events before and after Greece’s restructuring. Surprisingly, the markets did not perceive Greece’s restructuring as a fundamental weakening of contractual rights. This challenges the fear that European policymakers had of a negative market reaction, which led to delaying Greece’s debt restructuring. As a result, Greece made unnecessary payments to creditors for almost two years, eventually relying on European taxpayers’ funds.
However, it is important to note that the broader strategy of restructuring Greece’s debts did have a significant impact on investor confidence. It was Mario Draghi’s famous “whatever it takes” speech in July 2012 that began to alleviate the crisis and restore stability. While Greece has made a return to the bond market earlier than expected, it has predominantly issued bonds under foreign jurisdictions instead of local law.
This case study of Greece provides a broader lesson for countries in financial distress. Bondholders often exaggerate the risks and systemic consequences of debt restructuring. It is more beneficial, both for investors and countries, to take decisive and comprehensive action early on, utilizing all available tools. Let Greece’s experience serve as a reminder.
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