This belief — that an implicit official sector guarantee has quietly settled over every sovereign debt instrument issued by every geopolitically significant country on the planet — is a fallacy. The moral hazard implications of allowing this idea to prosper are staggering. More importantly, the official sector lacks the resources to make good on such an implicit guarantee, even if it wanted to do so.– Lee Buchheit, ‘Sovereign fragility’, 2014
Coming home to roost now though, isn’t it?
Late on Tuesday, Greece defaulted on the IMF.
(*We’re going to use the default term because that’s the plain English word when you don’t pay a loan back. The IMF uses “arrears” as an all-purpose alternative: not paying private creditors is also called arrears in policy documents.)
This was notwithstanding a last-minute rush to the ESM which the Greek prime minister made in a letter earlier. As technically a third bailout, it would supposedly cover €29bn of debt over two years.
These two developments are weirdly, actually about the same thing.
The ESM move in itself is yet another arbitrage on that belief: that official financing will always be there to cover debts coming due.
Crucially it is also one way to convince the ECB to roll over emergency liquidity for Greek banks: make it look like there’s something to talk about.
The IMF default, though, is about that belief coming politically crashing down.
And yet interestingly, in spite — or because — of this, the financial consequences of defaulting on the IMF don’t mean defaults elsewhere in Greek debt.
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Certainly the process will be dramatic.
Shortly after 6pm local time (1am in Athens) the front doors of the fund’s hulking building on Washington’s 19th Street NW closed, and with them the deadline for Greece to wire €1.5bn in payment. Managing Director Christine Lagarde prepared to“promptly” announce the default to the fund’s executive board.
Brazil’s representative on that board would probably have some extremely sharp words for the fact that the fund’s greatest ever credit exposure to a single country — and a relatively ‘developed’ one at that — has collapsed so severely. So may his African and Asian colleagues. Greece, they may observe, is supposedly scheduled to pay the last of the €23.3bn it owes the fund overall not until August 1, 2030.
Politically for the fund, this is indeed a disaster that will surpass even its Argentine fiasco at the beginning of the century.
Financially, it will also be one of the less important developments in Greece this week, which is important to bear in mind.
The ramifications of the IMF missing €1.5bn from Greece matter much less than a Greek bank missing the €60 rationed per diem to a withdrawing depositor, under capital controls.
The most important date is the July 20 payment for €3.4bn of bonds held by the ECB (technically €1.4bn is held by other eurozone national central banks) given the direct effects on the sustainability of ELA.
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Why defaulting on the IMF generally is a bad idea
Admittedly this idea might seem counter-intuitive. That’s probably because of the IMF’s famous preferred creditor status versus all other kinds of sovereign debt.
The fund gets paid before everyone else owed money by a country. It will never renegotiate terms in return for payment. Other creditors who tried to jump in line wouldn’t be very successful. Not even the judges in the Argentine pari passu casethought the clause allowed holdouts to be paid alongside the IMF. So cast-iron was the IMF’s seniority that it probably could talk about ‘arrears’, which have the semantic whiff of something that’ll be paid back soon, versus the finality of default.
Famous, but not legally formalised, and that is key here.
The first section of the IMF’s Articles on Agreement only refers to “adequate safeguards” on lending to members. It’s in part because the point of IMF seniority is so obvious: it’s what ensures the IMF can lend, at pretty reasonable rates for the borrower in a crisis. Often when governments ask for IMF help, they are already in a severe balance of payments crisis. Existing creditors are usually happy to see the cavalry arrive just to restore basic stability, before the inevitable negotiations begin with the government over restructuring their claims.
This also made the IMF’s method of enforcing service of its debt rather simple: if governments stopped paying it back, they would lose any access to this precious catalytic lending for the duration.
And then along came the eurozone debt crisis.
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For better or worse, the eurozone’s politicians did not only decide it was unthinkable for their governments to default and acknowledge their private debts were unsustainable.
They also brought in the IMF, and effectively rented its preferred creditor status (and a dubious line in debt sustainability projections) to ensure complete refinancing of those debts.
As Lee Buchheit put it in the above paper:
In short, to preserve the illusion that the sovereign debts of developed countries can always be refinanced, the official sector spent tens of billions of Euros effectively buying those debts at par once it became clear that the debts could not in fact be refinanced.
The point is, the nature of IMF seniority also deteriorated at the same time.
And at least in part, that’s why it looks weirdly simple to default on the IMF today.
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The EFSF loans
As eurozone officials built the architecture for official financing from scratch between 2010 and 2012, enmeshing the IMF within it, they often seemed quite confused about who was senior and who was not.
Remember when the ESM was also a preferred creditor, but somehow not as preferred as the IMF? The EFSF meanwhile was “at least pari passu” with private creditors.
In a way this effectively meant making the IMF’s status formal for the first time. It also led to weird effects. A relic of this is, perhaps, what the terms of the EFSF’s loans to Greece actually say about IMF default:
On one hand, this makes the effect of an IMF default appear pretty severe. Greece could suddenly have about €130bn of EFSF loans become immediately due if the EFSF’s board took fright at the IMF not getting paid.
But the key word above is “may”.
The issue is that the EFSF board are the eurozone’s finance ministers.
They would be well aware Greece couldn’t take the strain, and that acceleration wouldn’t exactly help negotiations, if they were to resume. If nothing else it would present the Syriza government with the ultimate opportunity to shift the blame to creditors. Precipitating a sudden stop is politically hard to countenance.
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The PSI bonds
The next set of debts to look at is Greek restructured bonds.
Greece’s 2012 sovereign bond restructuring, the biggest in history, was at least meant to stop official finance allowing its bondholders to cash out at par.
It still couldn’t quite give up on official financing however. One big part of Private Sector Involvement was giving bondholders a cash sweetener to accept the writedown. This was funded by the EFSF.
Because of that link, holders of the new bonds could in theory follow the EFSF if it demanded full payment after an IMF default:
But that firstly assumes EFSF acceleration, which is politically unlikely as mentioned.
There’s also another factor. Private claims on the Greek sovereign are now tiny as a proportion of its debt. Having heavily substituted its money for maturing bondholder claims before 2012, the official sector took over the remaining burden following the restructuring. (That’s Deutsche’s chart, below).
Even if bondholders could accelerate, the amounts are relatively small. And there’s the general truism that for a private creditor, suing a sovereign debtor for full payment after default is extremely difficult and costly, in terms of lawyers and time, even if you have a clever strategy. (See: Argentina.)
One way an IMF default won’t affect private bondholders much is ironically because the IMF’s cash helped ensure there weren’t many private bondholders left to be exposed to Greece.
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The ‘new’ Greek bonds
Just for the sake of completeness, bonds issued by Greece since the restructuring (in April and July last year: not the cleverest investments by asset managers) work much the same way:
The EFSF trigger’s already irrelevant as these bonds aren’t financed with cash from the facility. But the ‘after 2012′ language also excludes certain debts such as Greece’s pre-PSI bonds held out from the restructuring. That possibly also covers the ECB’s own Greek bonds, dating before 2012 and kept out of the PSI.
That could be important as we near July 20…
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Why it’s still a bad idea to default on the IMF
Anyway, the excerpts above are the bond-contract basis for the “cross default matrix” charts various bank analysts have been putting out on Greece in recent weeks. Here for example are Barclays, Morgan Stanley and Credit Suisse (click all to enlarge):
What the cross-default matrices can only hint at, however, is how the IMF’s role changed versus other creditors over the last five years and the risks grew. This culminated in Tuesday’s relatively inconsequential default.
Well, we say inconsequential.
If Greece leaves the euro, it will find itself in a balance of payments crisis. Its eurozone loans will become external debts, denominated in euros. The financial system will have to be rebuilt. A lot of macroeconomic policy advice will be needed.
Usually that’s when countries call in the IMF as the last lender.
And if Greece is still in default on the fund by then — that, to say the least, is going to be a difficult phone call to make to Washington DC.
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