Euro-zone governments have coughed up huge sums of money to keep four of their kin afloat since 2010. Most of it has gone toward making sure that private-sector creditors that have lent to Greece, Ireland, Portugal and Cyprus are repaid in full.
This choice has been expensive, and is now becoming increasingly controversial. A discussion has begun about cutting Greece's debts to its official creditors—meaning euro-zone governments could take losses. Greece, Portugal and Ireland have already gotten extra time and lower interest rates to repay loans to their European peers.
Associated Press
Cypriot students protested their country's €10 billion bailout package outside the presidential palace in Nicosia in March.
The latest example is the €10 billion ($12.9 billion) bailout of Cyprus. Of the first €2 billion installment, €1.4 billion will go toward repaying a bond issue that comes due on June 3. Conversations with bond investors indicate that much of that was swept up by hedge funds in February and early March, as the country was negotiating the rescue.
These investors paid less than the bonds' face value and now stand to make gains. In the three-year crisis, hedge funds have learned that, when a government receives a bailout, holding that government's bonds is usually a profitable bet.
In the case of Greece, which carried out the biggest debt restructuring in history in May 2012, private-sector creditors had been made whole for two years thanks to bailout money. The country, still drawing on a €174.5 billion bailout, is to this day repaying even those investors who refused to participate in its debt restructuring.
Using desperately needed cash for this purpose wasn't necessarily Greece's choice. The euro zone and the International Monetary Fund made plain that repaying Greek bond investors was a priority when they insisted that bailout money went to a separate, secure account that first pays holders of Greek government debt. Whatever is left can be used for other public needs, like paying pensions or teachers.
"Except for the belated Greek debt restructuring in 2012, this has been the invariable pattern of euro-zone sovereign-debt management: Taxpayer funds in the form of bailout packages have been used to repay, in full and on time, existing holders of sovereign bonds," said Lee Buchheit of the law firm Cleary Gottlieb Steen & Hamilton and an authority on sovereign-debt restructuring. He was hired to restructure Greece's debt and led many high-profile restructurings before that.
Now, at least one member of the "troika" of institutions that have managed the bailouts—the European Commission, the European Central Bank and the IMF—is having a change of heart.
A May IMF report questions whether devoting such huge amounts of public money to keeping private investors happy is a good idea. The fund says that, when a country asking for a bailout looks unlikely to be able to repay all its debt, simply using public money to redeem private-sector debt is a bad way to spend it.
It says it wants to "explore ways to prevent the use of Fund resources to simply bail out private creditors" and suggests countries' debts should be restructured early on, even before they get a bailout.
In the IMF's new view, giving private holders of government debt priority in bailouts may be a poor use for taxpayer funds both in the countries receiving the aid and in those providing it.Delaying a restructuring, the report says, "will accentuate problems of moral hazard and burden-sharing, particularly if, during this period, the claims of private creditors are replaced by those of the official sector."
The timing of the fund's intervention is interesting. This quarter, its own loans to Greece start to come due and euro-zone bailout funds will be used to repay the IMF.
At the same time, the IMF is calling on the euro zone to take losses on its rescue funding to Greece—to cut Greece's still-high debt burden—while maintaining the convention that it is a preferred creditor and therefore exempt from any such exercise.
But exempting itself from losses in the event of what is euphemistically called "official-sector involvement," or OSI, may not be that easy for the fund. "Now that OSI appears inevitable, the fund will surely be asked to participate," said Mr. Buchheit. "If the fund refuses, it just means that the full weight of the OSI must fall on European taxpayers. If the fund agrees to participate, its preferred-creditor status will be punctured. Neither is a pleasing prospect."
Others want to go much further and cut the debt held in private-sector hands before it gets to this stage. Ashoka Mody, a professor at Princeton University who until recently was a senior official at the IMF in charge of its involvement in the Irish bailout, said government debt in other bailout countries should be restructured pre-emptively, in acknowledgment of the fact that it is too large to repay.
The thought is enough to send chills down the spines of bond investors. Incurring billions of losses on bonds—once thought to be among the safest bets in the market and recorded as risk-free in banks' balance sheets under European accounting rules—would be traumatic. Speaking at an event at Bruegel, a Brussels-based think tank, Mr. Mody admitted to not having an answer to the question of what happens next.
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