Dealing with excessive debt is never pleasant but when it is countries rather than households struggling under the burden of loans they cannot pay, it is front page news.
There is speculation that several European nations will not be able to meet the interest (and/or principal payments) on their debts. And while some experts believe that changes in economic policy and to loans made under European stabilisation mechanism will allow these debts to be repaid, others think the measures will not work and some countries will need to restructure their debt. Such debt restructuring processes might sound very difficult to understand but they are not so different from steps heavily indebted companies and individuals use – albeit on a different scale.
Refinancing, haircuts and “reprofiling”
Debt restructuring is a process that aims to reduce the size or the cost of debt in order to minimise the financial toll of bankruptcy – or a “default” as it is sometimes named when applied to a country. There are many ways this debt restructuring can be done.
A country can pay off its debt by taking out a new loan on lighter conditions, such as paying back over a longer time, possibly at a lower interest rate. This is known as refinancing.
Another way is to persuade the country’s creditors – known as bond holders because sovereign debt is usually in the form of bonds – to agree to be paid a reduced percentage of their debt. This is known as a “haircut”, a term understood by just a fifth of respondents to an earlier eZonomics poll. In 2002, holders of Argentine debt received 25% to 35% of the full value of their debt, an example of a haircut.
Finally, a recent term to emerge is “reprofiling”. The Eurozone debt crisis jargon buster from the Financial Times says it means the same as a “soft restructure”, in which investors agree to change the terms of the bonds – often to extend the period over which debt is repaid.
History can tell us about Greek debt restructuring
Whatever the name, debt restructuring is more common than one might think. The book This time is different, by noted economists Carmen Reinhart and Ken Rogoff, examined 66 financial crises over 800 years. It showed Greece, for example, had defaulted four times since gaining independence in 1829.
Bringing it home
Like countries struggling with debts, private individuals and companies struggling with debts may be able to seek protection from their debtors so that they can carry on functioning financially. Although laws vary between countries, businesses can sometimes go into receivership so they can continue trading until they are sold and creditors repaid at least part of what they are owed. Individuals may be able to agree terms with lenders or be declared insolvent.
Like the stress testing for sectors and countries, companies and individuals can stress test before borrowing to ensure that more debt is not taken on than can be repaid, even in unexpected circumstances. Online resources such as ING’s Be Good At Money provide videos and tips for those wishing to learn more about personal finance.
Charities may also offer advice more suited to individual circumstances.
When bankruptcy is not an option
One reason sovereign debts attract so much debate is that, unlike individuals, countries cannot go bankrupt. Debt problems for countries can have substantial economic and financial effects that can ripple through many different countries (known as contagion) over many years.
For example, a default on Russian debt in the late 1990s played an important role in the documented collapse of Wall Street hedge fund Long Term Capital Management, the bailout of which, in turn, disrupted global financial markets. Because of the complexity and serious effects associated with sovereign debt restructuring, international institutions such as the International Monetary Fund may co-ordinate negotiations and organise loans to ensure debts are repaid in a manner that is acceptable to all involved.
Clarity Economics’ lead consultant