Wednesday, August 26, 2015

Lighten the load

Greece’s debt burden needs to be reduced, but maturity extensions on existing loans are not enough for Greece to return to the markets.

The IMF says that Greece’s debt burden is unsustainable. That is why the IMF will not contribute to the third assistance package (recently agreed by Europe and Greece) unless Greek debt is reduced. The problem is that an outright cut in the value of the debt – a haircut – is politically unacceptable, especially to Germany. The other option – extending the maturity of existing official loans further and lowering interest payments – is not enough for Greece to return to the markets. In order for this to be possible, the eurozone needs to refrain from threats of Grexit in case of a renewed crisis; to commit to making Greek debt sustainable even if economic growth comes in below expectations; and to make new government bonds issued to the market senior to existing official loans, such that new government bonds are serviced before official debt. These measures would also be in the interest of the creditors themselves: only if investors, businesses and consumers feel confident about Greece’s euro membership, can Greece grow and repay its debt.

Greece’s public debt will reach 200 per cent of GDP next year, according to the European Commission. This puts Greece just behind Japan as the most indebted country in the world, and in 2022, Greek public debt will still be 160 per cent of GDP – even with ambitious assumptions about economic growth and budget surpluses. Pre-2008 government deficits are not the only reason debt has spiralled out of control: the economic collapse since 2008 is also to blame. Before the debt restructuring in early 2012, both rising debt and the economic collapse raised the Greek debt-to-GDP ratio (see chart 1). Since mid-2012, however, Greek debt measured in euros has hardly increased. Only when measured against the shrinking economy has it grown. Greek growth is hence crucial to making Greek debt sustainable.

Chart 1: Greek debt in euros and as a share of GDP

Source: Haver

The largest chunk of Greece’s public debt is owed to other European governments and institutions. The maturities of these loans are long, the interest rates low and the interest payments already partially deferred. As a result, Greece only pays 4 per cent of its GDP in debt servicing costs – less than Italy and Portugal, despite their lower debt burdens (see chart 2). Much of Greece’s debt will not be repaid for a generation: the average maturity of loans from the EFSF, the predecessor of the permanent rescue fund ESM, is 31 years, and the last repayment is due in 2053, when German finance minister Wolfgang Schäuble would celebrate his 111th birthday. For critics of a debt haircut, these numbers suggest that the burden is sustainable and debt relief therefore unnecessary.

Chart 2: Government interest expenditure as a share of GDP

Source: Haver

But is Greece’s debt really sustainable? For countries that finance their debt on markets, the debt-GDP ratio helps investors to gauge sustainability, though it is far from perfect. For a country overwhelmingly financed by official creditors, and which enjoys low interest rate loans with long maturities, the ratio is not very informative. A different indicator is needed, and the IMF uses a country’s yearly gross financing needs, which comprise the government budget deficit and the maturing bonds that must be refinanced. This measure helps because it can be used to compare Greece to countries whose debts are financed by the market. And it is the stated goal of the new ESM programme that Greece should return to the markets. But private investors will only lend to Greece if they deem Greece’s debt to be sustainable. Only then will Athens be able to replace official creditors’ loans with private funds borrowed on the markets. And only then will official creditors get their money back.

In Greece’s case, the IMF argues from experience with other highly indebted countries that yearly gross financing needs should not be more than 15 per cent of GDP over the next decades for public debt to be deemed sustainable by markets. Greece’s annual financing needs currently stand at 25 per cent, down from 29 per cent last year. They are predicted to decline at first because many official loans have initial grace periods and repayment of the EFSF loans only starts in 2023, but they will increase thereafter to 20 per cent or more, depending on economic growth performance and the size of primary budget surpluses.

By the measure of gross financing needs, Greece is miles away from returning to the markets at sustainable interest rates. This is why the Greek debt burden needs to be significantly reduced even if Athens manages to deliver on the long-term primary budget surpluses of 3.5 per cent of GDP from 2018 and the economy grows as currently projected (around 3 per cent per year in 2017 and 2018, and 1.75 per cent in the long run).

A haircut would be the cleanest solution, since Greece would then be on its own and could return to the market. However, the eurozone does not want to give up control over Greece’s economic policies just yet. As long as Greece depends on official funding to roll over mostly official debt, it must abide by the conditions set out by the creditors. While current EU treaties do not foresee a haircut, Schäuble’s argument that such a step is legally impossible is mostly an attempt to hide these political motives. Moreover, governments in core countries such as Germany shy away from presenting their voters with the final bill.
However, lowering interest rates and extending maturities is not enough for a Greek return to the markets.
However, the option that remains – lowering interest rates and extending maturities – is not enough for a Greek return to the markets. The political uncertainty unleashed by the rise of Syriza and the creditors’ harsh response has undermined private investors’ confidence that Greece will remain part of the eurozone, grow and repay its creditors. If official creditors deem a haircut to be politically impossible, three other ingredients are necessary to resolve Greece’s debt burden.

First, policy-makers in Europe need to ensure that another debt crisis in Greece, sparked by a new recession or political crisis, will not put Grexit back on the table. Not only is it false to argue that Greece needs to leave the euro if it cannot repay its debts; the lingering threat of a Greek exit also hurts the economy and reduces the chances of the debt being repaid.

Second, debt relief by means of interest rate reductions and maturity extensions needs to be clearly and predictably tied to Greek growth. So far, the IMF and the Eurogroup of eurozone finance ministers have mostly blamed Greece for failing to reform when economic growth did not meet their unrealistic projections. Yet the projections themselves, as well as the counter-productive austerity policies implemented at the creditors’ behest, are to blame, too. A debt reduction plan must include provisions that automatically increase debt relief if growth disappoints, or investors will have good reason to question debt sustainability. Since such provisions could also reduce the Greek government’s reforming zeal, debt relief should equally be tied to the implementation of key reform projects. In practice, as long as the reform progress is deemed sufficient by an independent body such as the OECD, Greek debt would be made sustainable at every programme review by means of maturity extensions or further deferral of interest payments.
New private claims should be made senior to existing official and private claims on the Greek government.
Finally, in order to convince private investors to lend money to the Greek government, new private claims should be made senior to existing official and private claims on the Greek government – that means, Greece would prioritise the service of newly issued bonds over other loans. That would limit the risk of default for new private lenders, and signal that official creditors accept responsibility for the failure of past programmes. The amount of such new, senior debt should be clearly limited and agreed with the official creditors. The sustainability of the overall debt burden would be unaffected, but this plan has two crucial advantages. Greece could access markets a lot sooner than otherwise, freeing itself from the influence of the troika (now ‘quadriga’) of the European Commission, ECB, IMF and ESM. On the other side, the quadriga would have a new ally – the market – that would help to discipline Greek governments. Such an arrangement might also, depending on market appetite, reduce future official financing – something that creditors could sell as a political win back home.

Meaningful debt relief for Greece needs to happen: without it, the Greek drama cannot end. And it is in the interest of creditors, since the better Greece’s growth prospects inside the eurozone and the lower the risk of a renewed crisis, the greater the amount that will eventually be repaid. The IMF should not let the Europeans off the hook, and stand firm on its demands for debt relief.

Christian Odendahl is chief economist at the Centre for European Reform.


Hugo Dixon said...

You say that Greece cannot return to the market if its debt is simply extended, but you don't provide any evidence for this contention. I think it will be able to issue bonds perhaps as soon as next year if its programme is on track and its debt has been extended. Athens will by then be benefiting from some QE. Meanwhile, the official debt rescheduling that it will have received will have made new private debt de facto senior. If, say, no official debt is repaid before 2035, a new 10-year bond would be repaid long before that. With this de facto seniority, I don't see much point in making the new private debt de jure senior too. That would, admittedly, help Athens issue new 30-year debt, but I don't see that as the priority.

You seem to accept uncritically the IMF's argument that Greece's gross financing needs have to be below 15%. The IMF has provided little justification for this figure. But insofar as it has done so, the data refers to emerging markets not all highly indebted countries. It thinks 20% is the relevant figure for advanced economies. What's more, it admits that the 15% figure has a noise-to-signal ratio of 92%. In other words, even if we think 15% is the best guess for an early warning system, relying on it will very often generate either false alarms or fail to pick up imminent crises.

But even if we agree that 15% is the right figure, the question is what this means for Greece. The yardstick is clearly irrelevant for the next few years when it is in a bailout plan. We need to look beyond 2018. I know the IMF says Greece's financing needs will be over 20% for decades. But I don't think it has produced any calculation to back this up. The ESM, meanwhile, has said Greece's financing needs will average 12% over the next decade - again without a calculation to back it up. I'm not sure how to reconcile these different estimates. But one possibility is that the ESM is right for the next decade while the IMF is right for subsequent decades. If so, an extension of maturities coming due in the 2030s and 2040s to the 2050s and 2060s may be just the solution.

I agree that at least some of Greece's debt should be linked to GDP. I also think the current low interest rates on the official debt should be fixed.

Here's a column I wrote on the topic two weeks ago:

Christian Odendahl said...

Thanks for your comments, Hugo. My contention on why Greece cannot access markets even with (moderate) extensions is based on the IMF’s analysis of gross funding needs (GFNs, more on that below). I am assuming implicitly, of course, that the extension is not so dramatic that it qualifies as a de facto haircut. But such a dramatic extension is not on the cards.

The seniority issue is complex. On a pure liquidity basis and assuming market access throughout, you would be right. But there is a good chance that Greece ends up in a situation, in which a new government comes in and throws the MoU out the window. In that case, there would be no new tranches of aid, new doubts about Greek membership of the EZ, potentially new bank runs, and market access could be lost. If that can result in a default/restructuring, it does matter which bonds are deemed senior to others, and markets will make that calculation. My point is therefore not about 30y bonds.

I don’t think the IMF and ESM contradict each other that much. The IMF argues that GFNs will fall until 2022, and rise above 20 per cent from 2040 onwards -- and dramatically so if Greece cannot deliver on the primary surpluses and growth targets. Debt sustainability is always tricky to pin down, of course, but I would argue that the IMF’s 15 per cent is reasonable given that A) emerging markets do have something going for them, such as a currency to devalue, and B) underlying these 15 per cent are growth assumptions which are quite ambitious; put differently, you can either adjust the growth assumptions and use 20 per cent, or keep the growth assumptions and use 15 per cent. The IMF does the former in the robustness checks: with lower primary surplus and lower growth, the trajectory of GFNs goes beyond 20 per cent.

D Brown said...

My understanding is that the refinancing may begin in 2023 but doesn't exceed the IMF sustainability limits until the after 2030. Demanding real life debt reduction today against a theoretical problem fifteen years in the future appears to be an extreme position.