Debt Default

Debt Default, Restructuring, and Rescheduling

Debt default is failure of a borrower to make payments when due or to comply with loan terms as stated in the promissory note.

A borrower is in default vis-à-vis its private creditors as soon as it does not meet a financial commitment enshrined in its debt contracts.

It can be in default because it has not repaid the principal on time or because it has not paid interest.

A default is a credit event (an incident in the payment of debt obligations) that entails two consequences:
  • first, the rating of all tradable debt securities issued by the same borrower is downgraded by rating agencies to D (for defaulted) and stop being accepted as collateral by central banks for the provision of liquidity to commercial banks;
  • second, after decision by the International Swaps and Derivatives Association (ISDA)  Opens in new window, the default triggers derivative contracts such as credit default swaps (CDSs), which provide insurance against default risk.

For these reasons a default is inevitably a major financial shock.

These provisions apply to relationships to private creditors. Arrears in repayments to official creditors such as the IMF do not have immediate market implications. For example, Greece missed a payment to the IMF in July 2015, but Greek sovereign bonds were not downgraded to D Opens in new window.

Rather than to default, a sovereign borrower can renegotiate its debt with is creditors to obtain a rescheduling of the repayments, a reduction in the interest rate, or an outright reduction of the principal.

Negotiations with official creditors take place within the Paris club (or, at euro area level within the Eurogroup of finance ministers). As far as bank loans are concerned, they take place under the auspices of the Institute for International Finance (IIF) Opens in new window, the major international banks’ association.

Negotiations with bondholders are more difficult to organize because they are more dispersed. It is normally incumbent on the borrower to convene a negotiation with its creditors and to ensure that it involves a sufficient proportion of them.

An agreement reached with a majority of the bondholders can, however, be challenged in courts by a minority of holdout creditors. For this reason, bond contracts increasingly include collective action clauses (CACs) specifying that agreements approved by a qualified majority of the bondholders apply to all.

From an economic viewpoint, an important criterion is whether the renegotiation results in a reduction of the net present value of future payments (of the principal and the interest).

There can be such a debt relief without a reduction of the principal if the interest rate is reduced or if the borrower is granted a grace period (Greece in the 2010s has benefited from such a relief on official loans extended by the ESM, see the Greek Debt Saga below).

The Greek Debt Saga

In the 2000s, Greece recorded very large and in part hidden deficits, reaching a 15.5% of GDP deficit and a 127% of GDP debt ratio in 2009.

In spite of an exceptionally large fiscal adjustment, estimated by the IMF at 19% of potential GDP between 2009 and 2013 (IMF, 2017); a significant debt reduction negotiated with private creditors in 2012; and favorable borrowing conditions granted by the euro area partners Opens in new window, remaining deficits and the nominal GDP contraction resulted in the public debt reaching 177% of GDP at end-2014.

The IMF subsequently assessed that Greek debt was not sustainable unless a primary surplus in excess of 3.5% could be sustained, which was considered politically unrealistic.

However, the euro area creditors Opens in new window (partners countries through the European Stability Mechanism (ESM) Opens in new window, the financing vehicle set up in 2012 to provide conditional financial assistance to countries in crisis) were willing to provide favorable financing conditions but unwilling to write off nominal debt.

Germany, especially, insisted that debt forgiveness was illegal because Article 125 of the European Treaty (known as the no bail-out clause) states that “The Community shall not be liable for or assume the commitments of central governments … of any Member State.”

In net present value terms, Greece has benefited from a substantial reduction of its official debt burden, but — at the time of writing at least — in nominal terms there has been no debt relief.

A renegotiation resulting in a postponement of repayments without a change in the present value of future obligations is usually called a debt rescheduling. There is debt restructuring if the present value is reduced.