Eurozone: debt restructuring is the name of the (end) game

The Eurozone periphery has a problem of excessive external debt. How to solve it?

Some argue that the Eurozone's financial crisis is a remake of the Asian financial crisis in 1997. Austerity and structural reform is all what is needed to generate a sustainable current account surplus, eliminate dependence from external financing, cut down external debt and win back confidence from international investors.

Is that true? 

Let's look at the numbers:

1. Here is a chart depicting the current account of the countries at the center of the Asian financial crisis (Indonesia, Malaysia, South Korea, Thailand):

One year after the crisis unfolded, all countries had positive current account surplus ranging from 4.5% (Indonesia) to 13% (Malaysia). All countries were able to achieve current account surpluses throughout the 5-year period following the outbreak of the crises.

Here is the same chart for Eurozone's peripheral member countries:

Today, five years after the outbreak of the Eurozone crisis there is just one peripheral country with a clearly positive current account surplus. It's Ireland. It's roughly 2% of GDP. 

By 2017, according to IMF estimates - and it's anyone's guess how optimistically biased they are - there will be four countries with a positive current account surplus: Ireland, Spain, Portugal, Greece. And the numbers, as a percentage of GDP, are: 4%, 2%, 0.5%-1%, 0.5%-1%, respectively.

If you still think that the Eurozone financial crisis is a remake of the 1997 Asian financial crisis, think again. And yes, having your own currency and the ability to devalue it does make a difference in terms of speed of external imbalances' adjustment.


2. Others may claim that although the Eurozone is not in Asia, the net external debt of Eurozone's peripheral member countries is such that with austerity and structural reforms the situation can be turned around within a reasonable timeframe.

What do the numbers say? This:

Current net external debt (as a percentage of GDP)

Portugal: 107%
Greece: 93%
Spain: 92%
Ireland: 92%
Italy: 22%

For the sake of comparison

France: 18%
Germany: -37% (the minus means that Germany is a net international creditor)

This demands one observation. One question. And one answer.

The observation is: in terms of external imbalances and level of competitiveness, Italy is a very different animal from the other peripheral countries it is normally associated with. Italy is France, not Spain. Not really a surprise if one thinks about Italy's very strong industrial basis.

The question is: in 800 years of (more or less well) documented financial history, how many examples exist of countries with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that were able to avoid a debt restructuring or outright default (with foreign currency meaning one over whose issuance a country has no control)? 

And the answer is: z-e-r-o.

Therefore, the conclusion can only be that Portugal, Greece, Spain and Ireland will need a debt restructuring across the board, for both public and private debt, at some point over the next 2-3 years. With social discontent on the rise, this is the time left for structural reforms - all very much needed, but insufficient to reverse the country's external imbalances.


3. How to do the then unavoidable recapitalisation of Eurozone's banking sector following the periphery's debt restructuring?

The periphery's national governments will obviously not have the fiscal capacity to carry out bank bail-outs. With Eurozone's net public debt to GDP having just reached 90% - even economic powerhouse Germany is at 82% - and the social fatigue with bank bail-outs, don't expect the European taxpayer (via ESM) to be first in line to bear this burden. This leaves the private sector solution - arguably the only one truly compliant with a market economy, liberal democracy and open society - as the only one on the table:

- write-down of bank assets
- depositors up to Euros 100,000 are protected
- shareholders are wiped-out
- bondholders, both junior and senior, are bailed in and via debt-to-equity swaps become the new shareholders
- if this is not enough to fully recapitalise banks, depositors above Euros 100,000 are bailed-in and via debt-to-equity swaps become bank shareholders as well
- if this is still not enough, the European taxpayer (via ESM) will then, and only then, close the remaining gap


Does this sound pessimistic? For those who think it does, I can only say that I'm ready to happily change my views. For that to happen, I just ask for one single piece of evidence: show me one documented example of a country with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that was able to avoid a debt restructuring or outright default in the past.

Until then, the numbers are on my side.