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.

Thursday, August 06, 2015

Cameron's renegotiation plans: The view from Warsaw

David Cameron aims to get a quick agreement on the EU’s reform agenda but parliamentary elections in Poland on 25 October may complicate his plans. Although Law and Justice, the party leading in the opinion polls, belongs to the same political group as the Tories in the European Parliament, it may prove a tough negotiating partner in the European Council.

Soon after his election victory in May, British prime minister David Cameron toured Europe to discuss his plans to renegotiate the UK’s relationship with the EU. By making Warsaw one of the first stops on his trip Cameron hoped to improve relations with Poland, which deteriorated as his anti-migration rhetoric hardened. During his first term as prime minister, Cameron did not visit Warsaw at all.

But Cameron’s first meeting with prime minister Ewa Kopacz in Warsaw may well have been his last. The Civic Platform, which she runs and which has been in power for the last eight years (in coalition with the Polish Peasant Party), lost the presidential election on 24 May to the right-wing Law and Justice party. The victory of Andrzej Duda, who was sworn in on 6 August, has helped Law and Justice to catch the wind: it is now leading in the public opinion polls ahead of the October’s parliamentary elections, and stands a very good chance of winning them. If this is the case, Cameron will face a new prime minister at the renegotiation table.

What would this mean for Cameron’s EU reform agenda? Like the Conservatives, Law and Justice opposes transforming the EU into a fully-fledged political union, shares Cameron’s concerns about the current balance of power between member-states and EU’s institutions, and is wary of further eurozone integration and its impact on ‘euro-outs’. At first glance this makes the party a convenient partner for Cameron. But in the past, Law and Justice proved to be a difficult negotiating partner. During the 2007 negotiations on the Lisbon treaty, prime minister and party leader Jarosław Kaczyński opposed the new voting system in the Council of Ministers, which favoured the largest member-states. Kaczyński said that were it not for the Second World War Poland would now have a population of 66 million, and voting weights should reflect that. His comments caused bewilderment in Germany and elsewhere. The party is now positioning itself as more liberal, and nominated a woman, Beata Szydło, rather than Kaczyński, as its candidate for prime minister to appeal to more moderate voters. But Cameron has no guarantee that the party’s politics have changed. It could as easily confront Cameron as appease him.

Whether Cameron finds himself dealing with a prickly Law and Justice or a more emollient Civic Platform government after the elections, he will still need Poland (like all other member-states) to agree to his package of reforms. This insight sheds light on what Warsaw’s position might be on five issues Cameron has identified as central to the renegotiation.

First, Cameron wants to make the EU more competitive. He thinks that one way to do this is by cutting red tape and further liberalising the single market. This is one of the reform areas in which Cameron should find support in Warsaw. Poland is a clear beneficiary of the single market (between 2004 and 2013 its exports to the rest of the EU grew by almost three-fold, to reach a value of €114 billion in 2013). The current government shares Cameron’s view that the EU should serve its entrepreneurs and consumers. Law and Justice would probably also help Cameron on cutting red tape. The party wants to prevent the Commission from expanding its powers, and Cameron’s drive to reduce superfluous legislation fits this narrative neatly. But the party’s sympathy for deregulation does not mean that Law and Justice believes in Adam Smith’s ‘invisible hand’ in all circumstances. It has promised to impose a special tax on large retail companies, many of which are foreign owned. In doing so, Law and Justice is copying the hostile approach to foreign investors of Hungary’s prime minister Viktor Orban.

Second, Cameron wants to obtain an opt-out from the objective of ‘ever closer union’ set out in the Treaty on European Union. In June 2014 the European Council noted that the notion “allows for different paths of integration for different countries”, thereby leaning in Cameron’s direction. Poland did not oppose that wording. But what if Cameron demands that the treaty itself be amended to reflect the idea of “different paths”? Should the Civic Platform remain in power, it will probably oppose any immediate treaty change. If Law and Justice returns to power, it would perhaps be more sympathetic to Cameron’s arguments but the risk is that the party may use discussions on ‘ever closer union’ to argue for its own opt-outs. Its representatives have already hinted they would attempt to secure exemptions from the EU’s climate policy. If the party decides to use Cameron’s reform agenda to unpick what it does not like about the European project, other EU capitals will follow suit, delaying the renegotiation process.

Third, Cameron thinks that national parliaments should have a greater say in EU decision-making. Both Polish parties would show some understanding of Cameron’s concerns and might agree to a strengthening of the ‘yellow card’ procedure. But they would probably oppose collective veto rights for national parliaments. Ewa Kopacz is a former speaker of the lower chamber of the Polish parliament and recognises the need to engage parliaments better in EU matters. In 2012 she proved to be a skilful negotiator and broke a two-year stalemate between MPs and MEPs to set up the inter-parliamentary conference on EU foreign policy issues. If she remains in office, she will try to convince Cameron that there are ways to connect parliaments to the EU without giving them veto powers and hence without changing the treaties. Law and Justice would support a stronger role for national parliaments too. In an interview with the Polish daily Rzeczpospolita, Krzysztof Szczerski, the party’s leading expert on European affairs, complained that parliamentarians were not sufficiently involved in adopting EU laws and implementing measures. He acknowledged however that providing MPs with veto power would cause the EU’s institutional order to break down.

Fourth, Cameron wants to ask his partners for ‘safeguards’ for the single market. He worries that deeper eurozone integration in the area of financial services would damage Britain’s interests. This is one of the renegotiation areas where Civic Platform and Law and Justice are like to have completely different views. If Kopacz remains in power Cameron will find it difficult to convince her to help him negotiate more permanent safeguards for countries outside the eurozone. This is because Civic Platform want Poland to join the euro once it meets the convergence criteria and once the economic turmoil in the eurozone is over. In contrast with Britain, the Polish government has been more interested in participating in eurozone deliberations and its decision-making than in securing safeguards for ‘euro-outs’. The government has often pointed to Poland’s ‘pre-in’ status to justify being involved in talks about the eurozone’s future. In negotiations over the fiscal compact (the treaty introducing stricter eurozone budget rules) Warsaw won a provision giving not only ‘euro-ins’ but also other signatories of the compact the right to participate in euro summits whenever the architecture of eurozone or the implementation of the compact is discussed. For its part, Law and Justice dismissed this policy as too submissive to Brussels. Beata Szydło pledged that if she became prime minister she would put off any discussion of adopting the euro until the wages of Poles were similar to those of their Western European colleagues and she would abolish the post of the official in charge of euro adoption. Her mistrust of the euro makes her a natural ally of Cameron’s.
Cameron should realise that Poles see free movement as one of the EU's successes, not problems
Finally, in an attempt to please a more eurosceptic audience Cameron wants to limit access to unemployment and in-work benefits for EU citizens for the first four years after their arrival in the UK. But the British prime minister previously opted to discuss his concerns about the freedom of movement of people with Berlin rather than with Warsaw. He thought that putting his negotiation eggs in the Anglo-German basket would help him deliver reform - despite the fact that Poles are the largest group of EU migrants living in the UK (Poles constituted 8.7 per cent of all foreign citizens in Britain in 2013). This dismissive approach weakened Cameron’s hand in negotiations with Warsaw. As the elections near both parties are likely to harden their stance on Cameron’s free movement demands. In 2014, 80,000 Poles living in the UK registered to vote in the Polish presidential elections. This is not an enormous number, but if the parties are neck-and-neck, these votes will matter.

But Warsaw’s opposition to Cameron’s ideas is not merely a political calculation. He should realise that Poles see free movement of people as one of Europe’s greatest achievements, not a problem. The country was separated from Western Europe by the Iron Curtain for too long to sympathise with ideas putting freedom of movement at risk. If Cameron can focus on improving the EU for everyone, whether in Western or Central Europe, he may be able to get the support he needs from Warsaw, no matter which party forms the next government.

Agata Gostyńska-Jakubowska is a research fellow at the Centre for European Reform.