(Spain, Greece, Italy) - 'Significant debt forgiveness doesn’t mean equally significant losses for creditors.'

'..creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims..'

<blockquote>'Significant debt forgiveness doesn’t mean equally significant losses for creditors. Financial distress costs are triggered by the perception of a high probability of default. Spain’s creditors, of course, will hate to see their claims on Spain sharply reduced, but this is almost certainly going to happen anyway (I don’t think Spain has much chance of “growing” its way out of its debt burden without debt forgiveness), and if done in an orderly way, it is possible to compensate creditors for at least part of the debt reduction without incurring financial distress costs.

Spain can replace debt claims with a different set of claims whose payment schedule is positively correlated with economic performance. Instruments that pay according to GDP growth, the performance of the stock market, or land prices, for example, are the right way to line up the interests of the Spanish economy with those of the creditors. These are not unprecedented – Argentina provided GDP warrants on its defaulted 2001 debt – but they are used far too little. If a devaluation plus a sharp cut in Spanish debt causes Spain’s economy to come roaring back, as it most certainly will, creditors will be paid on the basis of how well the economy does, and can eventually recover a substantial part of the value of their original claims.

This is a very important point that few understand. High fixed claims will continue to drag down the economy because they increase the probability of default, and an increase in the probability of default sets off the self-reinforcing process of financial distress, in which agents behave in ways that worsen the debt burden, and worse debt burdens create pressure for agents to exacerbate their adverse behavior. But this doesn’t happen with high variable claims that are correlated with how well the economy does (like equity in a company, which cannot create financial distress costs). These claims are high when Spain can pay and low when Spain cannot, so they do not increase default probabilities at all. For this reason they will create absolutely no financial distress costs.'

- Michael Pettis, Some things to consider if Spain leaves the euro, May 25, 2014</blockquote>


Context

<blockquote>'The conclusion is simple: low interest rates do not solve the problem of high debt.' - BIS

A warning from the Bank for International Settlements

The Fed Won’t Let the Economy Heal, June 6, 2014</blockquote>