Phedon Nicolaides, 14 June 2015
As the markets are becoming increasingly convinced that Greece will soon default, here is a bold prediction: Greece will not intentionally default. The word “intentionally” is a hedge against accidental default.
Why do I even entertain the idea that I know better that the markets? The reason is simple. Until three days ago most economists had not considered how a judgment of the Court of Justice would have changed the trade-off between repayment of loans and default. Before I explain the significance of that judgment, we need first to understand the options which are open to a sovereign which contemplates defaulting on its obligations.In January 2013, the Bank of International Settlements ran a seminar on sovereign risk. The proceedings of the seminar were published in July 2013 in BIS Paper 72. In that Paper, Lee Buchheit explained that “sovereigns are unique debtors. Unique in two senses: they are uniquely vulnerable and they are uniquely protected. They are uniquely vulnerable in that, unlike a corporate debtor or an individual debtor, there is no bankruptcy code that applies to a sovereign.” Sovereigns are uniquely protected because they cannot be sued in foreign courts without their consent and their assets cannot be seized because they enjoy immunity.
Mr Buchheit acknowledged, however, that this doctrine of sovereign immunity has been restricted significantly during the past couple of decades. Nevertheless, a sovereign who defaults will shield itself from legal action by passing a law that binds domestic courts to recognise any debt restructuring or re-denomination of bonds and refuse to enforce any claims for compensation. Moreover, such a sovereign is unlikely to have assets outside its jurisdiction that can be seized. Embassies and consulates are under diplomatic protection.
This situation creates a stalemate. On the one hand, creditors are aware that judgments by foreign courts are unlikely to be enforced by the domestic courts of the defaulting sovereign [which will be barred by the law that re-denominates government bonds]. On the other, sovereigns know that when they attempt to regain access to international financial markets for a new loan, the old creditors will be there waiting for them. These are the reasons why most sovereign debtors and their creditors in most cases come to a negotiated solution.
This is indeed what has been going on between Greece and its creditors even since the new Greek government came into power at the beginning of this year. They have been searching for a negotiated solution. Much has been written about the need for debt forgiveness, the moral hazard of debt restructuring, and the economic and political repercussions of default. Each side has been calculating the costs and benefits of the different options and has been probing the other side to find its limits in order to maximise possible concessions. Much has also been written on whether the Greek government is bluffing. But the credibility of a bluff depends on what happens if it is called by the other side. As Thomas Schelling noted in his celebrated book “The Strategy of Conflict”, which partly secured for him the Nobel prize, the consequences must not only be dire for the other side, but should also be unpredictable and capable of spiralling out of the control of the one who makes the bluff.
We can now turn to the judgment of three days ago to understand how it has changed the balance of costs and benefits and has made the consequences more dire and unpredictable for Greece rather than its creditors.
In February 2012, the Euro group organised the world’s biggest debt-restructuring deal. It covered more than EUR 200 billion of Greek government bonds. Part of the deal involved a “haircut” for private investors who were asked to accept to write off about 50% of the face value of the bonds they were holding.
Some private holders of Greek government bonds reacted to the haircut [or, what was euphemistically called the “private sector involvement” (PSI)] by lodging lawsuits asking for compensation. So far they have all been unsuccessful. Some bond holders and, later, Cypriot depositors who were bailed-in when the Cypriot government closed down a non-performing bank that was burned by the Greek PSI, took action against the European Central Bank, the European Commission and the Council or brought action against Greece before the General Court of the European Union. They all failed. The General Court ruled last year that the decisions were made by national governments over which it had no jurisdiction.
However, some of the private bond holders chose a different strategy. Instead of bringing action against Greece or Cyprus in national courts or against EU institutions in EU courts, they initiated proceedings before courts in their own country, which in this case happened to be Germany. German courts are not bound by Greek or Cypriot legislation that enforced the PSI or the bail-in of depositors. The German holders of Greek bonds asked a German court to enforce their claim for compensation on the basis of EU Regulation 1393/2007. It is probably safe to assume that until three days ago most economists had never heard of that Regulation. It is about the transmission and enforcement of the judgments of the courts of one Member State by the courts of another Member State. The German court was unsure how the Regulation could apply to the claims for compensation and asked the Court of Justice of the European Union for guidance. On 11 June 2015, the Court of Justice confirmed that the claims for compensation did fall within the scope of that Regulation.
This is a bombshell. It means that anyone with a claim against Greece [or Cyprus] will be able to bring action before any court in the EU and, given the supremacy of EU law, Greek [or Cypriot] courts will have to enforce them despite the fact that Greek [or Cypriot] law has explicitly shielded the sovereign against such claims.
What are the implications? We should no longer speak of whether default can take place within the Eurozone [something that apparently most Greeks favour] or must lead to exit from the Eurozone. A defaulting Member State will have to leave the EU altogether, if it is to prevent its national courts from enforcing claims against itself! This changes the whole calculus of the current negotiations between Greece and its creditors seeming in favour of the creditors. But I hasten to add that this is not the end of the story.
Greece knows that default will not only cut it off from international markets in the short run but it will also precipitate an avalanche of claims for compensation. Short-term misery will be compounded by long-term misery. This appears to suggest that its creditors have gained the upper hand. Not really. It is now fairly certain that Greece will face claims for compensation that no one had expected. All the calculations done so far by the EU and IMF on the necessary Greek budgetary surplus will be thrown far off the mark. Greece will need debt restructuring. Since most of its debt is now held by public creditors, they will have to accept to reduce it, or prolong it for a long time.
Indeed, Greece will not default but not just because it will simply accept the terms of the creditors. It will not default because the creditors will come to recognise that Greece cannot repay them and at the same time compensate private investors. Even if Greece accepts all of creditors’ demands it will have to find new money to pay off private investors. That money will have to come from reduced claims by the current public creditors. There is an irony in this twist of events worthy of a Greek tragedy. The public creditors who sought to protect their holdings in 2012 by forcing haircuts on private investors will soon have to swallow the same bitter pill.
 See cases T-291/13 – T-294, various v European Commission & ECB; T-327/13 – T-332/13, various v European Commission & ECB ; T-38/14, Kafetzakis v Greece, Council, European Parliament, European Commission & ECB.
 The full text of the judgment can be accessed at:
 There is another possibility. The creditors refuse to restructure Greek debt and Greece defaults and eventually has to leave the EU. I assume that creditors would prefer Greece to stay in the EU.