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A Greek Catch-22

Updated: 2011-07-30 12:47

By Eduardo Levy Yeyati (chinadaily.com.cn)

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BUENOS AIRES – Desperate times bring desperate measures. The latest package to cope with Greece's insolvency offers a bond buyback to lighten the country's debt burden. In essence, this is a back-door debt restructuring: Europe's bailout fund, the European Financial Stability Facility (EFSF) would lend the money for Greece to buy back its own debt in the secondary market at deep discounts, thereby imposing a loss on private bondholders without the need to declare a default.

A recurrent characteristic of Europe's debt-crisis debate is a Latin American precedent. Indeed, many highly indebted countries in Latin America conducted similar debt buybacks in the late 1980's. Bolivia's 1988 buyback of close to half of its defaulted sovereign debt, an operation funded by international donors, is a classic example. But the most relevant Latin American experience with debt buybacks is a more recent and far less studied case: Ecuador in 2008.

President Rafael Correa had been toying with default since the 2006 presidential campaign (debt repudiation was part of his platform), and quickly earned a CCC rating from Fitch. The reasons invoked by Correa (legal concerns about how the bonds were issued in the 2000 debt exchange) were beside the point. The default threat was a way to depress bond prices in secondary markets, only to buy them back at a discount through the back door. That task was outsourced to Banco del Pacífico, which bought the soon-to-be-defaulted Ecuadorian paper at 20 cents on the dollar and above – a level low enough for a deep haircut but high enough to fend off "vulture" investors.

To speed things up, after the default was declared in December 2008, Ecuador completed the buyback with an inverse auction for the remaining bondholders, to be settled in cash – rather than a regular exchange in which the legality of undercover purchases was likely to be questioned. With the larger part of the outstanding stock in friendly hands, and institutional bondholders pressed to liquidate their positions in the midst of the post-Lehman Brothers selloff, the operation was a success.

This episode offers a few preliminary lessons on debt buybacks. The first concerns the market response. Judging from the recent evolution of Ecuadorian bond yields, it appears that markets have not punished Ecuador's behavior: Ecuador, an oil exporter blessed by the 2009 recovery in oil prices, could have returned to the capital markets shortly after the exchange. This is particularly notable, given that Ecuador's was perhaps the first opportunistic default (triggered by unwillingness, rather than inability, to pay) in recent history.

The second lesson, and the one most pertinent to Europe now, concerns the crucial role played by the default scenario. Indeed, almost two years of default threats by Correa were not enough to elicit a deep discount. Ecuador needed to go all the way to a "credit event" in December 2008 to be able to purchase the bonds at bargain prices.

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