Tuesday 5 April 2011

CGD: Privatization or Resolution?

I agree with Ricardo Reis. I had argued that the “pheripheral” countries banks should be resolved in a May 2010 column in Vox (and in a paper in 2009). The discussion about privatizing the CGD is not really relevant at this point. The banking system is well on route to be nationalized.

Portugal has to restructure its external debt (see German Economists Open Letter, Eichengreen, Rogoff, Financial Times op-ed, and my contributions at Vox and Expresso,). The reduction in Portugal's external indebtedness has to be sufficiently large. In my view Portugal’s net external indebtedness has to be restructured to well below 25% of GDP (from 85.3% at the end of 2010 plus FDI net external debt). I argued this point in an interview to Expresso. This means both private and public external debt has to be restructured. Banking sector net external debt (of approximately 50% of GDP at the end of 2009) represents a large percentage of Portugal’s net external debt.

Therefore, the country has to quickly create a bank resolution law, as done by England following the financial crisis. The aim of a bank resolution process is to reduce the banking system liabilities to put it in a more sound footing. A by-product of this process is that the banking system net external debt falls to more sustainable levels.

The key to restructuring Portugal’s sovereign debt is through changes in the law (Lei Quadro da Dívida Pública), as suggested in a paper by Bucheit and Gulati (2010). Nearly all of Portugal’s Government debt is sovereign debt governed by Portuguese law and jurisdiction (I am not sure about the conditions of that private placement of debt to the Chinese). After all, the conversion from the Escudo to the Euro was done through law changes.

What we face now in the European Union is not a normal negotiation. It is a negotiation between creditor and debtor countries with an economic value without precedent in the history of the Eurozone and probably in the history of the European Union. At the end of 2009, the non-consolidated net external debt of the Eurozone “pheripheral” countries was €1.3 trillion (gross: €4.2 trillion including Ireland’s IFSC). To this you have to add the external debt of a number of countries in the Eastern Europe block. So, game theory suggests that the incentives for opportunistic behavior between EU partners are huge, because the stakes are simply so large. I argued this point in a recent Vox column.

This is why it is now of outmost importance that Portugal refuse to accept the current “aid” of the EFSF/FMI or the ESM after 2013. This aid will substantially reduce the leverage Portugal has to negotiate with creditor countries if, as expected, it results in a change in the governing law and jurisdiction applicable to a part of Portuguese government debt. These are not aid plans, these are plans put together by creditor countries. In my view, not only are they detrimental to the debtor countries, they are detrimental to the Eurozone and the European Union as a whole (see my column in DN and this Independent.ie analysis that candidly and humorously makes pretty much the same point). There are instruments Portugal can use in the meanwhile to obtain further financing without compromising the conditions of its sovereign debt.

Finally, I agree with Pedro Pita Barros that it would be an error to leave the Euro and I believe the problems in the Eurozone can still be addressed.


  1. Portugal may need a bank special resolution regime (SRR) – it certainly looks like it may and even if did not need one it should have resolution built into its central banking framework anyway. Everyone should and perhaps by the autumn the European Commission will have (as promised) come up with some kind of community-wide framework directive focusing on cross-border aspects of special resolution particularly. However even if SRRs are being introduced after the fact to deal with the banking crises (UK, Denmark, Germany, Ireland) that are at the heart of the GFC or where already in place amended (as in the US), they should not be seen in such narrow terms as simply providing a mechanism for rapid liquidation outside the normal rules of commercial insolvency law (which they certainly must). The other point (equally important) is that SRRs must also sit within a philosophy of central banking and oversight of commercial banking that is rooted in and gives operational effect to structured early intervention and resolution (SEIR) as advocated by George G Kaufman and others over many years. The point of SEIR is that it offers those responsible for oversight with an approach to their duties that makes banks safe to fail as opposed to falling ad hoc into the TBTF trap. A perhaps useful survey of the issues involved in banking resolution may be downloaded from here while a recent central banker’s perspective on what SRR entails may be found here. There is further the question of what kind of banks and banking do we want? Here the whole debate about narrow banking, utility banking, casino banking and so on comes into play – all of which is very much live in the UK at present courtesy of the Vickers commission. John Kay gives us a good overview from a pro-narrow banking perspective here.

  2. Believing that there would be any economy left after a 75% hair-cut on Portuguese Public Debt, not to mention Private Debt, is certainly far beyond wishfull thinking.
    It is not supported by economic litterature, and it is not supported by the numbers involved.

  3. PS:
    And is not supported by the quoted document by german economists. They don't refer on that matter to Portugal or any other specific country, or even to Debt restructuring as being a good solution for the country involved. Their concern is, as would be expected, with the creditor well being, that is, with themselves.