Greece: the solution

Chronicles of a death foretold, or how, despite everything, the eurozone can survive with Greece
June 28, 2011
Austerity measures in Greece may have provoked protests—but tough cuts is just one part of the solution to the Greek crisis. Image: Joanna

The newspapers are writing the obituary of the euro or the excommunication of Greece or both, often with unseemly pleasure. But it is not so inevitable. There is a simple way to resolve the Greek problem that will strengthen the euro, not undermine it, that will lead German and other tax payers to recover the $145 billion they have pledged, not lose it, and that will not require ambitious institution building in Europe at a time when the electorate is euro-fatigued.

The solution requires three critical ingredients. So far we have seen much of the first two: an onerous Greek stabilisation package that triggers protests on the streets and the commitment to a substantial package of fiscal support to Greece by European countries and the IMF. But doubling and redoubling these will not shock and awe markets into submission if the third ingredient remains missing. No amount of additional flour will make the bread rise if there is no yeast. The missing ingredient is a debt swap that lowers Greece’s interest payments to affordable levels, frees up resources critical to support economic activity and reintroduces market discipline into fiscal policy.

This sounds like a debt default, and in essence it is not very different from a partial default—but if it is "voluntary" it is not a technical default. And the more misery there is on the streets of Greece and the more wrangling there is in Brussels and Berlin, the more likely it is to be voluntary. Today, the price of Greek bonds has fallen to a level which suggests that the market feels there is a near 50 per cent probability of a default within two years. On a mark-to-market basis, creditors to the Greek government have already lost more than the $145 billion support package. So, creditors may be willing to swap old Greek bonds for new bonds whose payments are backed by a European and IMF support package. The value of the bonds will be the same, but the rates of return paid on them will be considerably lower and the maturities twice as long. This would change Greece's annual interest burden from intolerable to bearable.

The debt swap is not an alternative to the domestic retrenchment and international support; it is a necessary accompaniment. The precise price and maturity parameters would be set to ensure that the expected return to creditors in the new bonds with the lower rates but greater certainty of payout is a little above the current expected return of the older bonds (after adjusting for their highly uncertain prospect of payout). This could reduce Greece’s interest bill from 5 per cent of GDP to almost 2.5 per cent. Over three years, this reduction in the interest bill would represent half of the fiscal retrenchment required under the IMF program, allowing them to achieve a decline in the fiscal deficit from 13 per cent to 3.5 per cent without cannibalising the economy to an extent that proves counter-productive.

Without a debt swap, but with the unprecedented 16 per cent of GDP fiscal retrenchment proposed by the IMF, Greece’s debt-to-GDP ratio would still rise to 150 per cent by 2013, growth would stall and interest payments on the debt would crowd out all else. The $145 billion package would only have bought peace for a couple of years as a massive resource transfer took place and sustainability questions re-emerged. In defence of its “no-default plan,” the ECB and the IMF argues that a debt restructuring in Greece would cause a contagion across Europe. But moving from a world of either full bailout or default, to one of 30 per cent haircuts—small enough to be swallowed by capital reserves—would be more sustainable and therefore more likely to quell contagion than stoke it. And remember, net interest payments as a percent of GDP are just 1.1 per cent in Spain, the destination of most spillover concerns. The IMF has considerable expertise in debt swaps and has just managed one of its most successful in Jamaica where 97 per cent of bond holders swapped older, high-coupon bonds for newer, low-coupon bonds, backed by an IMF package of fiscal support and conditionality.

Market discipline is dead; long live market discipline

In the fog of a financial war, policymakers are easily distracted by enemy flares. In recent weeks, a visitor from Mars might think the problem with Greece was to do with excessive speculation and trigger-happy rating agencies. Ironically, the problem was that speculation and rating downgrades occurred too late. In part, this was due to the markets and agencies refusing to trust the “no bailout" commitment between Eurozone member states (and so far they have been proved right). If, however, the lesson of Greece is that while eurozone members will support each other that support does not preclude everyone sharing the burden of stabilization (including creditors in a voluntary debt swap) then, in future, markets and agencies might be quicker to point out the emergence of unsustainable fiscal positions. I do not kid myself that more market discipline will be sufficient to address all of the euro’s fiscal challenges, but more is needed. There is much that can go wrong in Europe’s fumbling towards a voluntary debt swap that gives creditors a modest haircut and Greece a lifeline. But salvation is possible and probable if not certain. And it could allow the Greeks to argue that reports of their monetary death are much exaggerated.

Professor Avinash D Persaud is a senior fellow at the London Business School and Chairman of Intelligence Capital Limited