Manila or Bust?

As EU leaders wrangle over whether and how to give the 440 billion euro ($600 billion) European Financial Stability Facility (EFSF) more lending powers at next month’s summit, there has been no shortage of proposals in recent weeks about how best to get Europe out of its debt mess.

One increasingly popular idea for dealing with Europe’s debt crisis is to let Greece, and possibly Ireland and Portugal, essentially default. “Default is no longer unthinkable,” says Wharton finance professor Richard Marston. “I am increasingly convinced that both Greece and Ireland will have to do this. Look at the credit spreads. They are telling you that the markets expect a default. But a lot depends on how it is done.”

Another proposal is debt forgiveness, as Paul De Grauwe wrote in a January policy brief from the Centre for European Policy Studies. So rather than subjecting, say, Ireland to the “punitive interest rates” of 6% as part of its EFSF package — which the country will struggle to pay — the fund could charge 3.5%, which is the interest rate Germany pays “plus some ‘gentle’ risk premium,” thereby substantially reducing the fiscal effort Ireland would need to stabilize its debt ratio (likely to be around 110% of GDP by the end of this year) and lower the default risk. The challenge there, of course, is convincing creditor countries to provide the liquidity.

For Greece — the first country to turn to the EFSF last year — a solution said to be under consideration is what German news publication Spiegel calls “the Manila model,” reportedly named after a plan used in the Philippines in the 1980s. The voluntary Manila plan gives investors a choice: If they accept Greece’s discounted bonds (which would be bought back using an EFSF credit line), they have to book a considerable loss, but at least they would know that the losses would not be even greater. If they don’t accept the bonds, they agree to accept the risk of Greece becoming insolvent.

Marston says the Manila model “is an intriguing one because it lets the market set the terms at which Greece or any other country restructures its debt.” As he points out, there is already a huge discount on Greek debt — reflected in the huge interest premiums over German government bonds — so the restructuring would lower the debt burden substantially. What’s more, “the costs of such a buyback would be borne by the banks holding the debt.  So there are still pressures to avoid a writedown,” he notes.

Wharton finance professor N. Bulent Gultekin believes Greece could indeed end up with some sort of debt swap. “If lenders accept a flat discount, the [European Central Bank] or any entity will issue new bonds backed by their guarantees, and then speculation about a Greek or Portuguese default will disappear.”

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