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Why Official Bailouts Tend Not to Work: An Example Motivated by Greece 2010

Brian Pinto's picture

A newsclip in the DECPG Daily dated April 19, 2010, noted: “After Greek aid talks were delayed by disrupted air travel, Greek bond premiums relative to German bunds spiked again on Monday.  Air travel disruptions caused by Iceland’s recent volcanic eruption delayed the start of talks on a potential bailout package.... The delay could further weigh on already anxious markets”.  As it turns out, spreads on Greek bonds continued to rise, and significantly, even after the EU-IMF rescue package was finalized.  The reasons why are explored in an article Christophe Chamley and I wrote for The Economists' Voice

The basic idea is as follows.  Suppose a country is experiencing fiscal solvency problems. Then an official loan rescue package could spark a sell-off by private creditors if they perceive the official loans as senior to their own claims unless primary fiscal surpluses are raised substantially.  The sell-off would tend to depress bond prices and raise spreads relative to the benchmark country.

This is not the first time an official country bailout has run into trouble--nor will it be the last.  In 2001, Homi Kharas, Sergei Ulatov and I wrote a paper on the 1998 Russian crisis in which we argued that the design of the official rescue package hastened the Russian meltdown.  Here's what we said on page 43 of the paper:“A debt-based (official) liquidity injection that aims to boost confidence could worsen public debt dynamics while offering heavily exposed (private) investors a convenient selling opportunity....the financing portion of the package could actually trigger a crisis if the market is sufficiently skeptical about the implementation of fiscal and structural reforms. This argument is even stronger if the (official) liquidity injection involves debt that is perceived to be senior to existing claims of private creditors."

Our 2001 paper created a big stir because of its claim that the official rescue package helped trigger the crisis.  But it stood the test of time.  Writing in the January 2003 issue of Foreign Policy, Ken Rogoff, the then chief economist of the IMF wrote: "[The] official lending community, typically led by the IMF, is often unwilling to force the issue and sometimes finds itself trying to keep a country afloat far beyond the point of no return. In Russia in 1998, for example, the official community threw money behind a fixed exchange-rate regime that was patently doomed. Eventually, the Fund cut the cord and allowed a default, proving wrong those many private investors who thought Russia was “too nuclear to fail.” But if the Fund had allowed the default to take place at an earlier stage, Russia might well have come out of its subsequent downturn at least as quickly and with less official debt." [Rogoff, Kenneth. 2003. “The IMF Strikes Back.” Foreign Policy (January).] 

Unfortunately, there may be few options once a country reaches a situation where the market is pricing in expectations of a large default.  One solution would be to combine official loans with an upfront haircut for private creditors, which could then lead to both a smaller official package and less ambitious and therefore more credible primary fiscal surplus targets.

You can download the full text of The Economists' Voice paper at no charge from the journal's website. In it, you'll find a reference to the 2001 paper on the 1998 Russian crisis. 

Chamley, Christophe P. and Pinto, Brian (2011) "Why Official Bailouts Tend Not To Work: An Example Motivated by Greece 2010," The Economists' Voice: Vol. 8 : Iss. 1, Article 3. DOI: 10.2202/1553-3832.1821
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Submitted by anonymous on
Do I understand correctly your argument: you say that the only reason the package does not work is that private creditors perceive it as senior and sell off? This does not sound right - without a package they should have sold off even more rapidly but presumably they do not. Those packages that do not work simply mistake illiquidity with solvency and no amount of lending can hide that fact. Some also do nto work because either lack of transparency or lack of understanding mean investors are only now, with the official package, figuring out the mess a country is in.

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