A discussion on the “Sustainable Program for Debt Restructuring in Portugal”

16 March 2015 by Daniel Munevar

The purpose of this article is to discuss the salient points of the proposal recently presented by a group of Portuguese economists [1] to restructure public debt in Portugal.

The authors present a “Sustainable Program” (SP) to address the debt overhang of both the public sector and the financial sector. Indeed, the biggest contribution of the document is to address the elephant in the room when it comes to discussions about debt relief for the public sector: any attempt to drastically reduce the debt levels of the European public sector will directly undermine the solvency of the financial sector. Therefore, to seriously discuss measures that lead to a lasting and progressive solution to the European debt crisis requires addressing the sovereign-bank link that is present in most of countries in the continent [2]. The SP tackles this discussion and presents an interesting set of policy proposals that correctly tie in together the issues of public debt and solvency of the financial sector. This article will first present an overview of the proposal, then proceed to highlight several controversial issues that are embedded in it, and conclude with some additional comments.

The core of the SP is to restructure public debt in Portugal through what is in effect a debt swap. All of the outstanding debt of the public sector in the country (including local and regional administrations) would be replaced with a new set of bonds with equal nominal value to the outstanding debt. The key difference between the old and the new bonds would be that in the case of the latter, these bonds would have a fixed interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rate of 1% and a maturity period of 40 years. On the one hand, the interest rate reduction would provide significant relief in fiscal terms. This is because a lower interest rate implies a lower primary surplus target in order to stabilize debt. In other words, it provides a respite from austerity measures. On the other, the increase in the maturity of the bonds would eliminate funding pressures associated with the need to rollover short-term debt. In effect, the new bonds would only start the process of amortization of the principal in 2045. Thus, unless the country was to acquire additional debt, this would mean that the government would be effectively ring fenced from market pressures for 3 decades.

In addition, in order to deal with the impact of the SP on financial institutions, the proposal includes a bail in mechanism to ensure their solvency. First, the losses suffered by Portuguese banks on their portfolio of public debt would be passed on to shareholders and unsecured creditors, effectively eliminating their claims on the banks. Second, a 10% levy would be imposed on all depositors in order to finance a Public Guarantee Fund that would be in charge of protecting depositors with bank accounts under 100.000 euros. Third, 24% of the remaining claims of creditors of the bank, including depositors, secured creditors, and the entire claims of the Guarantee Fund would be converted into bank shares. As a result, the Guarantee Fund would end up controlling 36,4% of the restructured institutions, while depositors and secured creditors would receive 44% of the shares. It is important to highlight that throughout this process only depositors with bank accounts under 100.000 euros would receive full protection, whereas most of the losses would be allocated to current shareholders and unsecured creditors. Thus, the key to this proposal is that by trading Market activities
Buying and selling of financial instruments such as shares, futures, derivatives, options, and warrants conducted in the hope of making a short-term profit.
deposits and credits for shares, this mechanism ensures that former creditors have a direct interest in ensuring the stability of the restructured banks going forward. By bailing in the private creditors of the banks, the SP reduces to a minimum the requirement of additional public funds in order to bail out the banks.

From this very brief overview, its clear that the proposal has some clear strengths as it addresses simultaneously the issues of public debt and financial sector solvency. Nonetheless, its worth noting at least 4 issues. First, the SP doesn’t question the legality and legitimacy of the public debt. This implies taking the current debt levels as a given and therefore closes the door to the debate regarding the origins and evolution of public debt. It is a dangerous approach to follow, as it validates the moralistic approach to the debt crisis adopted by European authorities. In it, the debt crisis is a result of a combination of profligacy, corruption and inefficiency of the public sector in the periphery of Europe. As such, these countries are bound to pay in full their debts.

However, a closer look reveals the sheer nonsense of this type of argument. In the specific case of Portugal, the public debt of the country went from 51% of GDP GDP
Gross Domestic Product
Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another.
in 1999 to 68% in 2007 [3]. In contrast, during that same period, private sector debt (excluding the financial sector) increased by over 70 pp of GDP [4]. Before the crisis, European banks were happy to extend credits to Portuguese banks that in turn expanded domestic credit on a massive scale, which in turn fueled economic growth. This situation came to an end in 2008, and it was the government who had to intervene to stabilize the economy and the financial system. It was in this context that public debt skyrocketed going from 68% of GDP in 2007 to 128% of GDP in 2013 [5]. Even if Portuguese authorities were aware of the risks associated with the increase of private indebtedness, there was nothing they could have done to prevent this given European regulations.

In light of this situation, the moralistic argument in favor of a full repayment of the debt falls on its face. For example, between 2010 and 2012, the public debt of Portugal increased by 13.4 pp. of GDP due to one off charges associated with bank bailouts [6]. The question of whether the use of public funds to rescue private entities was the best, or only, option available would be left unanswered if the approach suggested by the SP were to be followed. Furthermore, Portugal has received 78 billion euros under the EU bailout program. The legality and legitimacy of the imposition of austerity measures, as a condition to receive the rescue funds, which have undermined human rights of the population is being increasingly put under question. Without a debate about the origins of the debt crisis, the wholesale deconstruction of the welfare state in Europe in the name of fiscal responsibility, and the EU 2020 competitiveness agenda, would continue unchallenged. Then again, the SP doesn’t address any of these fundamental issues and would force the public sector, and by extension entire societies, to pay unsustainable debts of questionable origins.

A second problem with the SP proposal has to do with the technical definition used in the text for the Maastricht debt criteria. The authors make a significant mistake when they identify the net present value of debt as the Maastricht debt criteria. As described by IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.

, the Maastricht criteria is clearly defined as “the total general government gross debt Gross debt This concept does not include government assets. The debt in the terms of the European Stability and Growth Pact (SGP) is a consolidated gross debt, meaning that it does not take into account either public assets or debts between public administrations. To take the example of a household of several people, the household’s debt, as understood in SGP terms, would be the sum of the total debt of those people but would not count any sums that they might have lent one another. Nor would the debt be reduced by the value of goods that belonged to the household, such as their car or their house. at nominal value outstanding at the end of the year” [7]. This might seem like a minor difference, but the definition of what is the proper measurement for public debt is of enormous importance. The measurement used by the authors of the SP involves calculating the value of the sum of all future debt service Debt service The sum of the interests and the amortization of the capital borrowed. obligations on existing debt, discounted at a given interest rate. This is a method traditionally used to calculate the effective debt burden of a country. The problem with this approach is that it renders the calculation to be extremely sensible to the determination of the discount rate. Given the uncertainty associated to the behavior of interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
, especially for extremely long periods of time, this is a less than ideal approach to compute debt. That is the reason why the IMF has set the outstanding nominal value of debt as the basic criteria to measure debt, given that is an observable and quantifiable variable. These characteristics are what made the nominal value of gross debt as the standard under which most of European regulations on public debt are based upon.

This might seem abstruse, but is of fundamental importance. The SP relies on a reduction of the net present value of debt in order to achieve its sustainability. As explained before, this approach has clear benefits to it. Nonetheless, the nominal value of the public debt would remain exactly the same. Because of it, Portugal or any other country in the EU that would follow this approach would still be in breach of the Maastricht treaty, and therefore subject to the full implementation of the EDP. As explained by the EU: “the EDP debt is measured at nominal (face) value. This entails that any change in the market (or net present) value of issued debt instruments is not reflected in the level of the EDP debt. Only changes in the nominal (face) value of debt have an impact on the amount of EDP debt. The ESA 95 sequence of accounts reflects any change in the market value of debt in the so-called “revaluation account”, which is “below the line” of EDP deficit/surplus. As a result, EDP deficit/surplus is not impacted by any change in the market (or net present) value of debt.” [8]

In other words, without a change in current EU regulations regarding the definition of debt and the criteria used to implement fiscal controls, a country would still be forced to implement austerity measures. This would be the case even though its effective debt burden would have been lowered by the debt swap envisioned in the SP. It would be a victory without the spoils, as the reduction in interest payments could not be used to finance counter cyclical policies as a way to re-start growth and alleviate the humanitarian crisis induced by austerity policies.

Furthermore, it’s clear that any solution to the debt problem must aim to restore growth in a sustainable way, both from a fiscal perspective and a current account balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. perspective. The ideal solution from an economic point of view for both issues would be a European system of fiscal transfers, which off course is at the moment not politically viable. Without it, the best option is to allow countries to aim, in a post-debt restructuring scenario, for a primary balance that stabilizes debt. The low interest rates envisioned in the SP would allow countries to use the resources that were being previously used to pay interest on the debt to implement a sustainable counter cyclical policy that restores growth without a further increase in public debt. Thus, for the proposal to work, the reduction in interest rates and extension of maturities must go with a revision of the EDP so as to allow countries to reduce the primary surplus. That being said, the extent of the output gap that currently exists in most of the euro area countries implies that even an increase of 3-4 pp. of GDP in public expenditure (facilitated by the SP) would not be enough to recover the lost ground since the crisis.

A third issue worth discussing with the SP has to do with the inevitable conflicts that arise with any kind of debt restructuring. In the current context is extremely unlikely that either private or multilateral creditors would grant the type of generous terms (1% interest rates for 40 years and no amortizations for 30 years) that are used in the baseline scenario of the SP. The undergoing negotiations between the Syriza government in Greece and the EU are a clear demonstration that debtor countries can hardly expect any type of concession from their creditors. Thus, if conflict between debtors and creditors is unavoidable why not aim for a more direct approach to tackle with the debt issue? It seems to be the case that in the face of the unwillingness of the creditors to recognize the evident reality that the primary surpluses required to pay down debt are simply not attainable, countries would be better off preparing themselves to take unilateral measures based on the full use of their sovereign rights. The organization of a debt audit, such as the one recently announced by the Greek Parliament, is probably one of the best options available on that regard. A debt audit would allow opening a public debate regarding the origins, legality and legitimacy of debt. Based on the findings of the audit a country could develop the legal arguments required to renege on the payment of debt that was acquired under illegal or illegitimate premises.

Besides the benefit of a public debate, a debt audit that leads to a substantial reduction of the nominal value of debt would have an additional benefit over a reduction of its net present value as advocated by the SP. As Michael Pettis pointed out recently “The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value.” [9] Among other things this translated into the fact that without a reduction in the nominal outstanding value of debt, the debt issue would still represent a hanging dagger over the future of a country. Without a credible fiscal policy, proper management of capital flows and current account balance, among other macro issues, the possibility of establishing a sustainable path to growth would remain an uncertainty. This would deter a reactivation in private investment, and therefore of the growth required to actually service the debt down the road. Given this conundrum, and in a context in which conflict is unavoidable, countries would be better off adopting alternative approaches that provide a direct resolution to the debt issue.

A fourth relevant issue involves the purpose and objectives of the financial system. The resolution mechanism envisioned in the SP to ensure the solvency of the financial sector doesn’t address the causes of the current problems. As it is, this process aims to exclusively reduce the liabilities Liabilities The part of the balance-sheet that comprises the resources available to a company (equity provided by the partners, provisions for risks and charges, debts). of the financial sector and to ensure its solvency. Even though the resolution mechanism would grant the public sector a 36% controlling stake on the restructured institutions, this is simple not enough to ensure that their objectives are properly aligned with public interest. One of the most overwhelming lessons from the financial crisis is that it’s simply not possible to rely solely on market mechanisms to ensure that the financial system fulfills its role as an efficient mechanism to allocate savings and investment. Without a profound change in the way finance works, a repeat of the current crisis would be unavoidable. Banks would go back to allocating funds to real state bubbles or other socially unproductive investments while excluding SMEs and small communities.

On that regard, the full recovery of the current crisis requires not only a progressive solution to the issue of public debt but also a complete makeover of the financial sector. Restructuring its liabilities to ensure the solvency of financial institutions without changing managerial structures, incentives and objectives would be a mistake. The financing of productive activities is a fundamental component of the proper functioning of a modern economy, and as such, too important to be left to the wanders of the market. The restructuring of the financial system as proposed in the SP should be complemented with an additional set of policies. A good starting premise is to consider banking as a public utility. This means, as its the case with other basic public utilities such as water or electricity, to put finance (at least commercial banking) [10] under a strict set of regulations, and possibly but not necessarily public ownership, so as to ensure the availability of credit for productive purposes on readily and available terms. Given the large amounts of exposure of the public sector to the banking sector, in the form of explicit guarantees Guarantees Acts that provide a creditor with security in complement to the debtor’s commitment. A distinction is made between real guarantees (lien, pledge, mortgage, prior charge) and personal guarantees (surety, aval, letter of intent, independent guarantee). , to assume further risks without aligning the incentives of finance with public interest is simply not an option.

Nevertheless, besides these issues, the SP represents a welcomed addition to the debate regarding progressive solutions for the debt crisis. For example it is especially relevant the attention the document devotes to the protection of small savers, who have invested their savings in public debt, and pension funds Pension Fund
Pension Funds
Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets.
. As the authors explain in detail, to provide special treatment to this specific group of creditors would create significant legal problems in the process of debt restructuring. Vulture funds Vulture funds
Vulture fund
Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors.
and other investors could claim that they are being discriminated, and as it was the case for Argentina, use foreign legal rulings to force payments in full. The SP addresses these issues by using Collective Action Clauses that force the rest of creditors to receive less favorable terms, while protecting the small savers. All in all, its clear that the crisis requires that the progressive political forces of Europe start developing clearly defined policy proposals that deal in a realistic way with the interconnection of fundamental issues such as public debt and the financial system. The SP is a good starting point to build upon.


[1The proposal is authored by Ricardo Cabral, Francisco Louça, Eugenia Pires and Pedro Nuno Santos under the auspice of the Institute of Public Policy Thomas Jefferson - Correia da Serra. The full document is available at: http://www.ipp-jcs.org/wp-content/uploads/2014/07/report-1-2014_.pdf

[2The biggest exception being Greece. The generous conditions granted to the creditors in the 2012 debt restructuring allowed for the exposure of European banks to public debt in Greece to be transferred to the European public sector. Thus, the sovereign-bank link was severed.

[3Portuguese Public Finance Council. (2013). Public Debt in Portugal. Retrieved from http://www.cfp.pt/wp-content/uploads/2013/11/CFP-APT-01-2013-EN.pdf

[4Bornhorst, F., & Ruiz, M. (2013). Private deleveraging in the Eurozone. Retrieved from http://www.voxeu.org/article/private-deleveraging-eurozone

[5Op. Cit. 3


[7IMF. (2013). PUBLIC SECTOR DEBT STATISTICS: GUIDE FOR COMPILERS AND USERS. (IMF, Ed.). Retrieved from http://www.tffs.org/pdf/method/2013/psds13ch5.pdf

[8European Commission. (2012). THE IMPACT ON EU GOVERNMENTS’ DEFICIT AND DEBT OF THE DECISIONS TAKEN IN THE 2011-2012 EUROPEAN SUMMITS. Retrieved March 14, 2015, from http://ec.europa.eu/eurostat/documents/1015035/2041357/Note-on-statistical-implications-of-summits-updated-12-A.pdf/5eacaf1a-30f3-48e0-81e3-ba14a77b5d7b

[9Pettis, M. (2015). Syriza and the French indemnity of 1871-73. Retrieved March 14, 2015, from http://blog.mpettis.com/2015/02/syriza-and-the-french-indemnity-of-1871-73/

[10This is in line with the proposals for a narrow banking system as advocated by John Kay. This involves separating the deposit and payment functions of banks from investment banking. The first two functions would be fully insured by the government, whereas the later would not.

Daniel Munevar

is a post-Keynesian economist from Bogotá, Colombia. From March to July 2015, he worked as an assistant to former Greek Finance Minister Yanis Varoufakis, advising him on fiscal policy and debt sustainability.
Previously, he was an advisor to the Colombian Ministry of Finance. He has also worked at UNCTAD.
He is one of the leading figures in the study of public debt at the international level. He is a researcher at Eurodad.




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