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GU ECON 102 - Official Bailouts

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-1-The Economists’ Voice www.bepress.com/ev February, 2011© Berkeley Electronic PressWhy Official Bailouts Tend Not to Work: An Example Motivated by Greece 2010ChrisTOphE ChAMlEy ANd BriAN piNTOMarket commentary in April 2010 suggested that once the IMF and EU aid package was finalized, Greece would be all right and bond spreads would fall. Exactly the opposite has been happening. We use the Greek event to illustrate why of-ficial bailouts in the form of loans are hard to implement successfully when countries have fundamental fiscal (‘insolvency’) problems, con-structing a numerical example to show why this should not come as a surprise. The intuition is that the official loan to the troubled govern-ment does not guarantee an increase in the net present value of fiscal resources and so ends up providing liquidity support while adding new official debt that market investors may perceive as senior, devaluing their own claims falling due in the future and prompting a sell-off.Here’s what happened: in March 2010, the Greek government announced fiscal aus-terity measures and began discussions with the EU and IMF. On March 26, Eurozone leaders endorsed a plan to help Greece avoid default, which would include IMF assistance. At the end of the month, the Greek govern-ment warned that it might not be able to rein in the deficit unless interest rates came down.There were then three successive announcements of assistance, each involving a substantial increase in the sum of money forthcoming:• The Eurozone announced a €45 billion package on April 12 (of which €15 bn from the IMF)• On Monday May 3, the size of the EU-IMF package for Greece was upped to €110 bn • Exactly a week later, a €750 billion pack-age was announced to help Greece as well as countries vulnerable to contagion from Greece (€440 billion in EU loans and guarantees; €60 bn in EU balance-of-payments support; and €250 bn from the IMF)These official ‘bailout packages’ consist of interest bearing loans which in effect replace maturing private debt; if grants were given instead, this would be an entirely different story as it would lower government indebt-edness and hence risk.Table 1 contains a timeline of key events with the accompanying bond and credit default swap (CDS) spreads for Greece. Christophe Chamley is professor of economics at Boston University; his research is in theoretical macroeconomics and public finance. Brian Pinto is at the World Bank.-2-The Economists’ Voice www.bepress.com/ev February, 2011Three observations are striking: (i) In spite of the announcement of progressively bigger bailout packages (April 12, May 3, May 10) Greek bond spreads continued to in-crease substantially.1 A peak was reached on May 7; but even though spreads fell on May 10 with the announcement of the mega €750 billion package, these spreads were much higher than on April 12. (ii) The decline in spreads from the peak on May 7 was much greater for the 2-year bond; but what is puz-zling is why this spread does not fall to zero, since the mega package amounted to guaran-teeing all outstanding two-year bonds! (iii) Notwithstanding the finishing touches to the mega-package on June 8, by June 15, spreads were much higher than on April 12 when a ‘mere’ €45 bn package was announced. The upward trend has been maintained subse-quently as shown in the last row of the table. Remarkably, the two-year bond spread is con-sistently higher than the 10-year spread after March 4, 2010.a numerical exampleWe start with a simple two-period situ-ation where the government has a Table 1 Key Events and Accompanying Market Signals for GreeceDate/Event 2-year bond spread10-year bonds spreadCDS spreadJan 4 2010: Reference point 183 233 281March 4: Greece sells new 10-year bond after announcing fiscal austerity measures429 297 307Stage 1 bailoutMarch 26: Eurozone reaches accord on Greek contingency plan but at market interest rates346 305 296March 31: Greek government warns it may not be able to cut fiscal deficit if bond yields stay high416 344 343April 9: Friday prior to bailout package announcement 593 399 426April 12: Monday, Eurozone announces €30 bn plus €15 bn from IMF for Greece 502 350 364April 14: Investors skeptical about bailout implementation 571 394 433April 23: Greece formally requests assistance 932 560 616April 28: S&P downgrades Greece to junk 1512 693 750Stage 2 bailoutMay 3: Monday, EU-IMF €110 bn package announced for Greece 947 544 643Stage 3 bailoutMay 7: Friday: Contagion fears hit global markets 1773 965 941May 10: Monday, massive EU-IMF €750 billion funding facility announced to help Greece and curb contagion 693 481 586June 8: EU puts finishing touches on its €440 bn rescue package 708 561 795June 15: Moody’s cuts Greek rating to junk 811 641 815January 28, 2011: Markets seem unconvinced 1198 831 892Source: Bloomberg. Bond spreads relative to German bonds. CDS spread is the five-year credit default swap spread based on New York data.-3-The Economists’ Voice www.bepress.com/ev February, 2011liquidity but not a solvency problem, in the sense that the present value of primary fiscal surpluses equals that of the debt to be repaid. Let’s call this Scenario 1. In Scenario 2, the government has a solvency problem as well and has to explore options on how to deal with it. Table 2 shows these scenarios.The debt service due in each period is shown in the second row of the table; the risk-free rate is assumed to be 5 percent. In Scenario 1, the government has debt service payments falling due of $100 in period 0, but can generate a primary surplus of only $75. But this is not a problem because it can bor-row $25 at the risk-free rate r*=0.05 to make up the difference; r* is the interest rate in a benchmark country like the U.S. or Germany. This means the total amount it must repay in period 1 is 25x1.05+157.50=$183.75, which can be exactly met out of the primary surplus in period 1.In Scenario 2, there is a problem because the primary surplus for period 1 goes down to $175. On equity grounds, the government decides to give an identical haircut to creditors in both periods.


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GU ECON 102 - Official Bailouts

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