Raghu Rajan’s solution to European debt crisis

Very good piece by professor Raghu Rajan in FT about how Europe’s bail-outs costs should be shared. I do not agree with everything but I think it offers a better alternative to the European problem than most solutions presented to us so far.  Here are some very good points from his article (my highlights):

“If this funding is senior and therefore higher priority to private debt – as IMF funding typically is – it will be harder for these countries to regain access to markets. For the more a country borrows in the short term from official sources, the further back in line it will push private creditors, making them susceptible to larger haircuts if the country eventually does default.”

“In the best of worlds, distressed countries would default as soon as private markets stopped funding them, and they would impose the losses on private bondholders. In the world we live in though, if the view is that Italy and Spain are solvent, or are too big to fail, then official funding should be structured so that it gives these countries their best chance.”

“The simplest solution is that official funding should be treated no different from private debt – best achieved if official sources buy country bonds as they are issued (possibly at a predetermined yield) and agree to be treated on par with private creditors in a restructuring. As the country regains market confidence, the official funding can be reduced, and eventually the bonds sold back to the markets.”

“There is, however, one more element that is needed to assure markets that the resolution is politically viable. Citizens across Europe, whether in rescued countries or rescuing countries, will be paying for years for a mess that no one feels they are responsible for. Banks may not all have voluntarily loaded up on distressed government bonds – some were pressured by supervisors, others by governments – but many have made unwise bets. If they are seen as profiting unduly from the rescue, even as they return to their bad old ways of paying for non-performance, they will undermine political support for the rescue, and perhaps even for capitalism.

So a final element of the package ought to be a monitored pledge by the banks in the eurozone that they will not unload bonds as the official sector steps in, that they will be circumspect about bonuses till economies start growing strongly again and that they will raise capital over time instead of continuing to deleverage – if this hurts equity holders, they should think of this as burden sharing. Cries that this is not capitalism should be met with the retort: “neither are bail-outs!”

 

The entire article here.

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