Wednesday, 20 May 2015

Li goes LAC: China´s Latin Role

China´s Premier Li Keqiang has just started his tour through Latin America (shorthand LAC, to include the Carribean), with promise of US$ 50 billion in infrastructure investment. LAC pins high hopes on broader and stronger China engagement on the continent. After a great first decade this century, the region is not doing well, give and take some cross-country differences in economic performance. But while China´s Latin role is definitely rising, it is likely to remain relatively limited, I will argue here.
LAC is already highly exposed to China: The cooling of China’s economy, a major driver of global growth, has sparked a commodities glut that has left LAC exporters of soybeans, crude oil, iron ore and copper with lower prices and export receipts. LAC growth has become increasingly China-centric over the 2000s[1]. But beyond the simple mechanics of growth linkages, the impact of China´s ongoing rebalancing away from hard equipment investment could be as significant as the impact of its growth moderation for many economies in Latin America that are materially reliant on commodities exports for growth.
A growth model that is dependent on investment is also commodity-dependent (or at least biased towards the use of industrial and energy commodities such as copper, oil and iron ore), while a consumption-led growth model would be less commodity-intensive. The rating industry has taken note of LAC vulnerabilities caused by China growth dependence: “The LatAm sovereigns that are more exposed to a slowdown in China … are Chile (Aa3 stable), Venezuela (Caa3 stable), Peru (A3 stable), Uruguay (Baa2 stable) and Brazil (Baa2 negative)”.[2] In 2013, Chile´s exports to China for instance totaled 7.4% of its GDP, mostly copper. Between early 2012 and early 2015, the copper price dropped by half as China´s investment led growth started to slow. The corresponding income effect of lower terms of trade must have been very strong indeed. Chile´s annual income windfall over the past 40 years, almost two percent of GDP[3], has turned into heavy losses until recently when copper prices have started to climb back up. Brazil government finances, with its economy contracting by about 1% this year, felt forced to cut funding to national development bank BNDES, a traditional source of cheap financing for infrastructure projects.
With government finances running dry, LAC is therefore trying hard to woo Chinese investment. Deep Chinese pockets are projected to cut transport channels from the Atlantic to the Pacific oceans. Infrastructure investments, such as a rail link from Brazil to Peru´s Pacific Coast, are required to lower transportation cost in view of higher LAC-China trade ($240bn in 2014). A Nicaragua-crossing interoceanic canal is being estimated to trigger $50bn of Chinese investment to Central America. Trade links are also important beyond raw materials as LAC is interested in pushing manufactured and services (tourism) exports to China. China has now surpassed the US as Brazil´s biggest trade partner, and hopes are for diversification and value-added enhancement.
Meanwhile, China has to deploy excess savings and to employ excess Chinese infrastructure-building capacities.  That is why China is wooing mining concessions in LAC. In a broader global context, China has experienced a diplomatic transformation. Chinese diplomacy has evolved from “keeping a low profile” to “proactive and enterprising”. China’s “One Belt, One Road” (OBOR) strategy and her 21st Century Maritime Silk Road target developing countries. After Asia and Africa, it is now LAC´s turn.  Geopolitics comes in via intensified travel diplomacy (Xi Jinping 2014 in Argentina, Brazil, Cuba and Venezuela, now Li Keqiang in Brazil (again), and also Chile, Colombia and Peru; summitry (e.g., CELAC-China ministerial early 2015 in Beijing; BRICS summits) and cooperation plans such as the China-LAC cooperation plan 2015-19. China is opening scholarships and training opportunities (both 6000) to LAC. For some countries (Venezuela, Ecuador, Argentina), China has assumed lender-of-last-resort functions.

Despite big announcements and high hopes, however, China´s Latin role will is likely to remain limited compared to Asia and Africa. Here are some barriers to China´s engagement:
·         China is growing increasingly worried about the model of lending secured against commodities. Last year, Chinese loans to Latin America reached $22 billion, surpassing the combined lending of long-established institutions such as the World Bank and the Inter-American Development Bank, according to estimates from the Inter-American Dialogue. But default concerns have been creeping in. Venezuela, for instance, has borrowed more than $56bn from China, mostly from the China Development Bank, but a steep drop in crude prices has added to stress on its already ailing economy. Argentina´s government, facing severe dollar shortages and a protracted legal dispute with U.S. creditors, has repeatedly turned to Chinese credit to bolster depleted foreign currency reserves. Growing concerns over its financial exposure to socialist-leaning South American partners such as Venezuela and Argentina are pushing for diversification of Chinese finance in the region[4].
·         LAC is traditionally part of US sphere, and that will well limit China-LAC ties. A Chinese perspective The Diplomat, 31-03-2015: “Culturally, Latin America has been part of Western civilization. Geographically, it borders the U.S., thus the regional economies are closely tied to the United States’. Some Latin American countries rely on the U.S. for security or are deeply influenced by the U.S. Meanwhile, the U.S. considers Latin America as its “backyard” and has a great impact on, or even dominates, some Latin American countries’ domestic and foreign affairs. U.S. influence is wielded through the Organization of American States (OAS), the Inter-American Development Bank, bilateral economic cooperation and assistance, multinational corporations, military aid, and even military intervention. When it comes to Latin America and the Caribbean, U.S. tolerance for China to expand partnerships and economic interests within this region is one thing; the development of military and security ties is quite another. Conversely, China could set up security and military alliances with African states if necessary, as that continent is far less influenced by the U.S. and Europe.”[5] The recent warming of Cuba-US relations must be viewed as a US response to China´s advance in America´s traditional backyard, I think.
·         Finally, both Latin America and Africa are less important than Eurasia in China’s OBOR strategy. And the China-Latin America relationship is of less significance than China-Africa ties, considering the factors of geographical distance, the United States’ great influence, weak economic ties, cultural differences, and a lack of ground transportation. Additionally, the relationship between China and Africa has developed for more than half a century, while economic ties between China and Latin America have only taken off in the past two decades.
Put in perspective, while China´s Latin role is clearly on the rise –  very visibly this week – it is likely to remain relatively limited.

[1] For evidence, see Christopher Garroway & Burcu Hacibedel & Helmut Reisen & Edouard Turkisch, 2012. "The Renminbi and Poor‐country Growth," The World Economy, vol. 35(3), pages 273-294, 03.
[2] Moody´s Investor Service, 2015. “Latin America: Vulnerability to China Growth Slowdown Vary by Sector”, Special Comment, 4 February.
[3] Gustavo Adler & Nicolas Magoud, 2013. „Four decades of terms-of-trade booms”, Voxeu, 4 July.
[5] Xue Li and Xu Yanzhuo, 2015. „Why China Shouldn´t Get Too Invested in Latin America”, The Diplomat, 31 March.

Tuesday, 7 April 2015

AIIB to Dwarf ADB Loan Portfolio

After the UK decision to join AIIB in March 2015, an avalanche of Western and Asian countries recently filed application to join the AIIB. China´s magnetic attraction and the isolation of the US and Japan became palpable in fast motion. Representatives from 21 Asian countries had signed the Memorandum of Understanding on Establishing Asian Infrastructure Investment Bank (AIIB) on 24 October, 2014 in Beijing. By end March 2015, more than fifty countries –two third Asian, one third non-regional - had filed application to join as founding members of the Beijing-based Asian Infrastructure Investment Bank (AIIB). Its subscribed capital is US $ 50 billion, half of which is paid in by China.

Like the NDB (better known as ´BRICS Bank´ and, compared to AIIB, advancing in slow motion), the authorized capital for the AIIB is US $ 100 billion, the paid-up capital US $ 10 billion. The NDB has been established with a global remit to lend to developing countries. The AIIB is focused on Asia.  Both new institutions are intended to concentrate on funding infrastructure projects. One of the major barriers to economic development in low and middle income developing countries is the lack of critical infrastructure such as ports, railways, roads and power.

Although AIIB and NDB were launched in 2014, the decisions to create them reflect the growing discontent for many years amongst developing nations that the governance structure of the IMF and World Bank has not evolved to reflect the increasing weight of emerging markets in global GDP. AIIB and NDB can be viewed as part of a concerted Chinese attempt to build a Sinocentric global financial system, as an alternative to US hegemony, as voice reform in the established IFIs has failed. At the APEC Leaders’ Summit in November 2014, China´s President Xi also announced the creation of a new Silk Road Fund to improve connectivity in Asia, for which China will provide USD 40 billion of capital funding. The BRICS also had suggested in July 2014 an IMF-style contingent reserve facility (“Contingent Reserve Arrangement”), for which the five countries agreed to earmark $100 billion of their foreign-exchange reserves for swap lines on which all members are entitled to draw. The China-Africa Development Fund and the China-CELAC infrastructure fund are further examples of recent attempts to develop a global Sino-centric finance infrastructure.

Table 1: Loan-Equity* Ratios at AAA-rated MDBs, latest


Source: Various press releases and annual reports (assessed on 30 March 2015 at the MDB websites).

*Equity is defined as the sum of paid-up capital and reserves.


The AIIB is likely to eventually dwarf the ADB in terms of loan portfolio (and annual lending). The level of leverage (loan to equity ratio, the reverse of usable capital to loan ratio)) depends on the risk bearing capacity of a multilateral development bank (MDB). MDBs forgo such leverage opportunity if they transfer amounts to trust funds (such as IDA), which do not use a capital base to mobilize resources from financial markets and pass the amounts received from donors to beneficiaries at a rate of 1:1. A very simplified MDB balance sheet has the loan stock on the asset side and paid-up capital plus borrowings on the liability side. A trust fund (or concessional window) with no borrowings can thus achieve a loan-equity ratio of one only. Borrowings at the level of equity enable a loan-equity ratio of two, borrowings double the size of equity push the loan-equity leverage ratio to three. AAA-rated MDBs in 2014 recorded a loan stock-usable capital ratio of between 2 and 4 (Table 1). Usable capital of one US dollar, defined as paid-up capital plus reserves, thus could underpin a loan stock portfolio of USD 2 to 4 at the four leading AAA-rated MDBs.

The AIIB can be expected to obtain AAA rating by the leading rating agencies. Apart from strong support by the major shareholder China, the recent joining by highly-rated non-regional countries (including G7 countries) will lay the foundations of high intrinsic financial strength. Compared to the AAA-rated African Development Bank (AfDB), the AIIB will likely be less burdened by credit-negative considerations than the AfDB, which is burdened by a challenging operating environment across Africa. The regional exposure to Asia and the sectoral exposure to infrastructure should confer the AIIB a loan portfolio with relatively strong credit quality.


Table 2: Paid-up Capital and Total Loan Stock, US$ billion

Paid-up Capital
Loan Portfolio
Loan-Capital Ratio

Source: Various press Releases (assessed on 30 March 2015 at the MDB websites).


Table 2 compares the paid-up capital of the ADB and the AIIB as well as actual and prospective loan portfolios. Recent data show paid-up capital to stand at US$ 5.9 billion for the ADB, backing a total loan portfolio (outstanding plus undisbursed) of US$ 75 billion. (The respective numbers for the IBRD are paid-up capital of US$ 14 billion that underlies a total loan stock of US$ 152 billion.) If AIIB succeeds in building reserves from retained earnings and other sources, it could eventually reach a similar loan-(paid-up) capital ratio as ADB (12.7) and IBRD (10.9). Applying the ADB leverage ratio to AIIB, their paid-up capital (US$ 10 billion) could end up underpinning a loan portfolio of US$ 127 billion (AIIB). Applying the smaller IBRD leverage, the AIIB loan portfolio would still reach US$ 109 billion eventually, absent (negative) substitution or (positive) agglomeration effects respectively. While it is much too early today to be confident whether the newcomer will reach the financial performance achieved by ADB and IBRD, the scenario laid out here might well suggest that AIIB will end up with a higher loan portfolio than at present ADB. Consequently, expect the China led development bank to have a leading impact on multilateral development lending in Asia, hence on global financial governance.

Sunday, 29 March 2015

The Slow Demise of the Dollar Empire

The US dollar is strong these days. But this is just a snapshot. The gradual end of the dollar empire is in the making.

The IMF has just announced that it will review the composition of basket of special drawing rights (SDRs ) later this year. To maintain the external pressure for further liberalization of the Chinese economy, the People Bank of China (China´s central bank) has an interest to have the renminbi (or yuan) included in the SDR basket already in 2015. So far, only four global currencies share the honor to be part of that basket. All are part of the Western bloc (dollar, €uro,pound and yen). To qualify for inclusion in the SDR, the Chinese authorities need to initiate a series of liberalizing reforms : financial openness to promote currency convertibility and a wider intervention band for flexibility and market determinination of the renminbi.

SDRs are a kind of artificial money held at the IMF, money not traded on foreign exchange markets. That´s why SDRs are at times dubbed the Esperanto of global currencies as it does not perform all the functions of money. Although SDRs can act as part of official foreign exchange reserves, they can neither be used for intervention in currency markets nor as an anchor currency. Nonetheless, the inclusion of the Chinese currency in the SDR basket would be a very big step in the recalibration of the current world order, which was largely built after WWII. Why is that?

The BRICS have been calling for quite some time to replace the US dollar as the international reserve currency, possibly with the SDR basket. This request was reiterated several years ago by the UN Commission on the Reform of the International Monetary and Financial System, headed by Joseph Stiglitz. True, the US dollar so far is fulfilling an important  network role for the global economy. Like English as a world language, it has features of a natural monopoly. But as the SDR basket consists only of currencies in rich countries, any demand of poorer countries for a reserve currency´(to build up FX reserves, say, for precautionary motives) is akin to ´reverse aid´ to the four SDR countries.

Seigniorage is an 'exorbitant privilege' (Valéry Giscard d'Estaing in 1960) for the country whose currency is the international reserve currency. In addition, the one-sided dependence of the SDR basket (about 80% of which are currently based on dollar and euro) acts pro-cyclically on commodity prices as commodity-based currencies are missing in the SDR basket.


The inclusion of the renminbi in the SDR basket would have both  signal and real effects for China and the international monetary system. China's high-risk currency mismatches would be mitigated by the internationalization of the renminbi; the international monetary system would be more balanced. A further opening of the Chinese financial system might perhaps improve the efficiency of resource allocation, but it is almost certain to also increase China's financial risks. China´s promotion of financial reform and capital-account opening by joining the SDR basket might perhaps be compared in retrospect to the stimulatory effect of China's WTO accession on SOE Reform. Unless it served as a major step to a big financial crash...

If history is any guide, it will take thirty to seventy years until the dollar empire is replaced by a multiple currency system or even a renminbi empire. Already today, China is in the lead as the world's largest economy, exporter and net creditor. Great Britain´ pound sterling lost only during WWII the dominant reserve currency role to the US dollar although she had lost the lead as an economic power to the United States as early as 1872 and in 1914 had turned into a the net debtor country. It was only the growing convertibility of the US dollar after WWI that enabled the dollar´s steady climb to a pole position as international reserve currency . Now it is China's turn ...

Thursday, 19 March 2015

Kindleberger´s Global Leadership Concept: A Scorecard for China, Germany & the US

It is often suggested (and disputed) that the Pax Americana is coming to an end. The term has connected with the international leadership power (also: hegemonic power) of the United States, at least since the end of World War II. The Bretton Woods institutions, the OECD and NATO can be understood as a steering instruments under American leadership. The beginning of the end of American leadership takes place in a world that is - unlike the 1990s after the collapse of the Soviet Union and its satellites -  no longer felt as unipolar, but as a multipolar or apolar.

The unstoppable economic rise of China since more than three decades and her more recent assertive foreign policy stance, especially in the context of the BRICS group and global financial diplomacy, have established China's international leadership ambition[1]. Even Germany has been catapulted (albeit reluctantly) by the Euro crisis in the role of European leadership[2] – an outcome very different than intended by Jacques Attali and François Mitterand when they pushed for the Euro.

The US, China and Germany: How far do these three countries (still or already) satisfy an international claim to be a benevolent, solidary hegemon in the constructivist sense foremost defined by Charles Kindleberger[3]? The idea of ​​a well-intentioned leading power requires willingness to bear a disproportionate share of the costs of the provision of global public services for the stabilization of the international financial and economic system. Specifically, Kindleberger has defined five global public goods:

• acceptance of open markets to absorb exports from crisis regions;

• the countercyclical provision of long-term financing;

• a stable exchange rate system;

• securing macroeconomic coordination;

• a willingness to act as ´lender of last resort´ in systemic crises.

How well do the US, China and Germany meet the provision of global public goods in financial and economic area - yesterday and today? The table attempts a schematic representation. X stands for ´positive´, (X) for mixed, O negative performance. To be sure, the calibration has to be subjective and somewhat arbitrary. But it has the merit to point the attention to the leaders, away from the ´periphery´, when it comes to assuming responsabilities for avoiding or solving crises such as the current Eurozone crisis.

Scorecard for Global Kindleberger Goods

Public Goods
Open markets
Long term finance
Exchange rates
Macro coordination
Last resort lending

Open markets: Germany and the US were so far, despite their agricultural protectionism, classic free trade nations; China as a developing country, instead, still prioritizes  the establishment and protection of new industries. However, TPP and TTIP are darkening the US free trade status; they undermine global trade through multilateral WTO rules, while they focus on enforcing primarily US standards not least to ´contain´ China[4]. Should Germany sign TTIP, it would retrograde from a multilateral free trade status adhered to for long.

Long-term financing: China is assuming nowadays a role model in the countercyclical provision of long-term loans. With generous development and export credits by Chinese national financial institutions in developing countries since the late nineties, China started to lead; in recent years, through establishing parallel multilateral development banks, China has started to challenge the US-led World Bank and the Asian Development Bank[5]. Germany has a well-equipped development bank and participates prominently in the EIB; but Germany in the euro zone has failed to provide constructive and solidary leadership – notably by hindering fiscal union and a common market for government bonds - despite its large contribution to the various Eurozone bailout funds. The United States is anything but a a provider of anticyclical long-term finance: with the focus on private portfolio investment and the ubiquitous pressure to dismantle capital controls, the US have a tradition of rather sponsoring pro-cyclical and crisis-prone finance.

Exchange rate stability: Since the collapse of the Bretton Woods system of fixed exchange rates, monetary policy of the US Federal Reserve has avowedly been based on US national objectives alone. China is still effectively pegging the renminbi to the US dollar and currently thereby preventing a global currency war at a time when the Bank of Japan and the ECB deliberately weaken the external value of their monies. China shows here global responsibility (but for how long?). Germany plays a rather destructive role in the euro zone that it helped create. Sure, together with France, Germany has infringed debt and deficit criteria set by the Maastricht Treaty and prevented sanction proceedings launched by the European Commission against her. But what matters more is that Germany has actively torpedoed   the creation of the institutional prerequisites for an efficient monetary union - fiscal and banking union as well as common government bonds.

Macroeconomic coordination: Here, the US remain the undisputed leading power, for example in the context of the G20 group, where they exert pressure on macroeconomic coordination and reduce external imbalances such as (beggar-thy-neighbor policies in the form of large surpluses in the current account). A neo-mercantilist mindset and widely ignored (or refuted) Keynesian economics prevent the understanding of the need for global macroeconomic coordination in both China and Germany - according to the St. Florian principle: "O heiliger Sankt Florian, verschon' mein Haus, zünd' and're an", equivalent to "St Florian, please spare my barn, set fire to another one".

Lender of last resort: The US Federal Reserve remains the unique international lender of last resort in the event of a global systemic financial crises. Due to underdeveloped financial markets and existing controls on capital movements, the People's Bank of China cannot play this role. But China's high foreign exchange reserves and public finances have been used vigorously in the global financial crisis 2007/8 to effectively prevent a decline in economic performance. Increasingly, China - parallel to its activities in global financial diplomacy – enters the scene as White Knight in allied countries in the context of the Second Cold War. Germany, by contrast, has undermined via Bundesbank, conservative media (such as the FAZ) and its constitutional court ´lender-of-last-resort´ actions by the ECB such as the ´Outright Monetary Transaction´ (OMT).

The listing of global public goods show to what extent China, Germany and the United States contribute to secure the financial and economic stability in each respective case. Germany has clearly failed to play the role of benevolent hegemon with the Eurozone. Do you still wonder why the world is familiar with the Washington Consensus and the Beijing Consensus but has never heard about a Berlin Consensus?

[1] Do read the excellent analysis by Hongying Wang (2014), „From “Taoguang Yanghui” to “Yousuo Zuowei”: China’s Engagement in Financial Minilateralism“, CIGI Papers No. 52, Waterloo, On:  Centre for International Governance Innovation (CIGI).
[2]  Robert Kappel (2011): “On the Economics of Regional Powers. Theory and Empirical Results“, in: Nadine Godehardt and Dirk Nabers (eds.): Regional Powers and Regional Orders, London: Routledge: pp. 68-92; Siegfried Schieder (2014), „Zwischen Führungsanspruch und Wirklichkeit: Deutschlands Rolle in der Eurozone“, LEVIATHAN: Berliner Zeitschrift für Sozialwissenschaft, 42. Jahrgang, Heft 3, S. 363-397.
[3] Charles Kindleberger (1973), The World in Depression, 1929-1939. Berkeley: University of California Press; and, idem (1986), „Hierarchy versus Inertial Cooperation“, International Organization, Vol. 40.4, pp. 841 – 847. There is some debate whether Kindleberger distinguished clearly enough between the terms ´hegemon´ and ´international leader´. While the hegemon “presumably wants to do it on his own behalf, a leader, one who is responsible or responds to need, who is answerable or answers the damand of others, is forced to ´do it´ by ethical training and by the circumstance of position” (Kindleberger, 1986, p. 845).
[4] L. Alan Winters (2014), „The Problem with TTIP“,, 22. March.
[5] Sebastian Heilmann et al. (2014): “China’s Shadow Foreign Policy: Parallel Structures Challenge the Established International Order”, MERICS China Monitor, Nr. 19, Berlin: Mercator Institute for China Studies (MERICS).

Tuesday, 20 January 2015

Dealing with Greek Debt: Two Lessons from the Past

On Sunday, the Greek will vote a new government. A Syriza victory, and default on Greek public (and private) debt, are in the cards. With increased political uncertainty, the outflow of bank deposits has been massive, once again. Greece’s outlook was revised to negative from stable by Fitch on Jan. 16. Wolfgang Münchau recently has put the case for debt relief forcefully[1]: “In Greece, the political choice is essentially between the status quo of fiscal austerity and an alternative of negotiated debt default. The economic argument for the second course of action is compelling. Greek debt runs at 175 per cent of gross domestic product. The country does not need to service all that debt right now. Greece pays no interest on the “official” debt from the EU until 2023. But this is only eight years away — well within the horizon of any long-term investor. (The first alternative) is a version of extend-and-pretend: extend the loans, and pretend that you are solvent. The history of international debt crises tells us that these strategies are always tried, and always fail.”

Despite various debt reschedulings and haircuts suffered by lenders, Greece´s gross debt stands now at 175% of GDP[2]. Table 1 provides details. Most of the debt was initially held by French and German banks (in that order). Meanwhile, the German taxpayer is the biggest ultimate creditor to Greek debt, indirectly mostly via the EFSF.

Table 1: Greece´ Debt Burden, end 2014

€, bn
%, GDP (€182 bn)

                   Source: FAZ, courtesy Markus Brunnenmaier


Christina Lagarde was quoted (by The Irish Times in an interview released six days ahead of the election) that she reserved judgment on whether Greece´s mountain of debt was sustainable. After several years in office, it is high time she familiarized herself with the IMF Debt Sustainability Framework. For market-access emerging countries (a status which Greece has returned to recently), a gross debt-to-GDP ratio of 70% is considered as a threshold of debt solvency (IMF, 2013, Table 7)[3]. To reach debt sustainability, therefore, even after all the haircuts and rescheduling negotiated over the past years, Greece´s debt would have to be cut by 60% at least.

The past provides two lessons that would militate for immediate debt relief in that size.

First, there is ample precedent within Europe for both debt relief and debt restructuring. Greece´s biggest creditor has repeatedly benefitted from generous debt relief in the past. As pointed out by Benjamin Friedman[4] at a recent BIS conference, Germany has been one of the prominent beneficiaries of debt forgiveness throughout the last century; on multiple occasions, the Western allies had restructured German debt: 1924 (Dawes Plan), 1929 (Young Plan), 1932 (Lausanne Conference) and 1953 (London Debt Conference). Friedman concluded: “There is no economic ground for Germany to be the only European country in modern times to be granted official debt relief on a massive scale and certainly no moral ground either …  The entire (1953) agreement was crafted on the premise that Germany’s actual payments could not be so high as to endanger the short-term welfare of her people … reducing German consumption was not an acceptable way to ensure repayment of the debts. The contrast to both the spirit and the implementation of the approach taken to today’s overly indebted European countries is stark.”

Morally therefore, Syriza follows the right approach by trying to extend the debt relief beyond the insufficient haircut originally agreed upon, which still carries the costs of a default without the benefits of a clean slate. Ex-post solvency counts for much more than manners, procedural details and how the final haircut will achieved. In financial markets, bygones are bygones and, once you have made the point that the default was inevitable, ex-post solvency is what counts.

Second lesson: the curse of defensive lending in the presence of a debt overhang. Defensive lending obliges lenders to refinance themselves the loans when they come due. It can be measured by the extent to which new loans (in gross terms) are explained by debt service of the debt. Cohen, Jacquet & Reisen (2007[5]) have shown for low-income countries, mostly African, the painful decades (especially the 1990s) of defensive lending before the HIPC initiative finally reduced the debt load sufficiently for those HIPC beneficiaries to gain market access: To Forgive is to Forget.

Levy Yeyati (2011) has succinctly stressed that the Greek debt crisis resembles more the 1980 debt crisis in Latin America (“the lost decade”) than the more recent Argentinean debt problems:

“The first approach to the Latin American debt problem was denial. Supposedly, all that was needed was time to implement a drastic fiscal adjustment, for which the International Monetary Fund, sponsored by the United States, would provide the needed refinancing. In 1985, the Baker Plan elaborated on this approach by introducing private sector involvement through the voluntary rescheduling of bank loans, so as to lengthen the fiscal adjustment period. The result was a massive debt overhang that discouraged investment and triggered frequent spells of capital flight and disappointing growth that was reflected in growing debt ratios. This became known as the lost decade for Latin America. Only in the 1990s did the players involved in the debt rescheduling recognize that an insolvent country requires some genuine debt relief, in the form of a reduction in the nominal value of its debt, or a “haircut”. This new understanding took the form of the Brady Plan, which exchanged unrecoverable, unmarketable bank loans for discount marketable Brady bonds – bonds that would be the seed of the emerging markets asset class”.

Again: To Forgive is to Forget.

Historically and now, defensive lending relies on a fiction: the supposed ability of most heavily indebted countries to reduce their obligations over time; it has usually ended in political unrest. In the past, "debt overhang" theories have shown that if there is some likelihood that, in the future, debt will be larger than the country's repayment ability, expected debt-service costs will discourage further domestic and foreign investment and thus harm growth. Potential investors will fear that the more a country produces, the more it will be "taxed" by creditors to service the external debt, and thus they will be less willing to incur costs today for the sake of increased output in the future.

This argument is represented in the debt "Laffer curve" (e.g., Krugman, 1988[6]), which posits that larger debt stocks tend to be associated with lower probabilities of debt repayment. On the upward-sloping or "good" section of the curve, increases in the face value of debt are associated with increases in expected debt repayment, while increases in debt reduce expected debt repayment on the downward-sloping or "bad" section of the curve. Besides confirming this inverted-U relationship between debt and growth, Patillo et al. (2002) have quantified the two critical turning points (for developing countries): the overall contribution of debt to growth appears to become negative at 160-170 percent of exports and 35-40 % of GDP (in net present value terms)[7]. The latter roughly translates to 70% in face value of the Greek debt stock. Unless Greece comes down upfront to a debt stock of maximum 70% of GDP, solvency remains fiction.

Let the Greek vote for Syriza on Sunday. It makes economic sense.

[1] Münchau (2015), Wolfgang Münchau, “Political extremists may be the eurozone’s saviours”, Financial Times, 4/1/15
[2] According to Zettelmeyer et al (2013), “the Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief – over 50 per cent of 2012 GDP – with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors”. See Jeromin Zettelmeyer et al., „Greek debt restructuring“, Economic Policy, 513-563. Zettelmeyer is now the chief economist of Germany´s Ministry of Economics…
[3] IMF (2013), Staff guidance note for public debt sustainability analysis in market-access countries, 9th March.
[4] See Gillian Tett, “A Debt to History?”, Financial Times, 16/1/2015. The file underlying the Friedman speech can be downloaded at; title: “A Predictable Pathology”.
[5] Daniel Cohen, et al. (2007), “Loans or Grants”, CEPR Discussion Papers No. 6024, January.
[6] Paul Krugman (1988), “Financing vs. Forgiving a Debt Overhang”, NBER Working Papers No. 2486, January.
[7] Catherine Patillo et al. (2002), "External Debt and Growth," IMF Working Paper 02/69.