ZEW Study on Government Debt - Outright Debt Relief Significantly Decreases Risk of Serial Sovereign Debt Restructurings

Cutting the debts of heavily-indebted countries can weaken or even completely eliminate their willingness to implement much-needed reforms. Despite the risks associated with a haircut, it also bears positive effects. For example, it substantially reduces the risk of follow-up debt restructurings. This is the result of a study conducted by the Mannheim Centre for European Economic Research (ZEW).

Throughout the sovereign debt crisis in Europe, there have been repeated calls in favour of a debt restructuring for countries like Greece, which will hardly ever be able to pay back their enormous debts. There are two ways to reduce the burden of debt-ridden countries: first, an outright debt cut including agreement on the part of creditors to forego a major share of their money invested in government bonds; second, an indirect relief of indebted countries by extending maturities or lowering interest rates. Both restructuring methods lead to a relief, the substantial difference being that the relief resulting from an outright debt cut is immediately visible for creditors.

To find out if and in what way the two types of debt restructuring affect the probability of follow-up restructurings in the case of overly-indebted countries, ZEW researchers examined the history of all restructurings sovereign states underwent between 1970 and 2010. The study shows that serial restructurings are not an exception, but, in fact, a recurring phenomenon in many countries. In 41 per cent of the debt restructuring cases examined, debts had to be rescheduled again within the following three years.

The ZEW study on debt restructuring procedures suggests that a direct haircut, which immediately reduces the nominal value of the debt burden, reduces the probability of follow-up restructurings by twice the rate of equally-sized reductions in net present value due to interest rate reductions and maturity extensions. Christoph Schröder, ZEW researcher and author of the study, explains why a direct debt cut halves the risk of follow-up restructurings: "Lower interest rates on government bonds and maturity extensions, in particular, can be short-term solutions to serious liquidity problems of debt-ridden countries, but the total debt level remains unchanged. Reducing the nominal value of sovereign debt, however, leads to a long-term relief that is directly visible to market participants. This helps to rebuild a country's debt sustainability."

Rating agencies, for example, take the actual debt level into account. When the debt level is falling relative to GDP due to a haircut, this may improve the country's rating. A lower nominal value also reduces accrued interest, which helps to reduce the pressure on public budgets when it comes to repaying sovereign debts.

It is not only the type of haircut, but also the volume of restructured debt that determines whether further restructurings will be necessary in subsequent years. The higher the relief following the first restructuring, the lower the probability of future restructurings.

For further information please contact

Christoph Schröder, Phone +49(0)621/1235-390, E-mail christoph.schroeder@zew.de