Article / 26 July 2017 at 14:30 GMT

Macro Outlook: Greek farce continues — #SaxoStrats

Head of Macro Analysis / Saxo Bank
France
  • Exiting financial help programme next year looks quite unrealistic for Greece 
  • 3 scenarios: a fourth adjustment programme, extension of maturity, or debt haircut
  • Greece’s financing needs expected to reach almost €19 billion in 2019
Greek theater
  Ancient theatre of Epidaurus. And the drama continues... Photo: Shutterstock


By Christopher Dembik

Greece’s comeback to the financial markets represents a successful PR exercise for the country that will strengthen the position of those, within the prime minister's Syriza party, who favour exiting the financial help programme next year. 

But this option looks quite unrealistic taking into consideration the country’s financing needs, which are expected to reach almost €19 billion in 2019, unless Athens accepts high borrowing rates that will increase indebtedness and constrain potential GDP growth. In fact, there are only three possible options for Greece once the current aid plan ends in August 2018: a fourth economic adjustment programme, an extension of the loans' maturity or a nominal debt haircut.

So let's take a look at these scenarios in more detail.

A fourth economic adjustment programme

This is the least desirable solution because it would lead European creditors to lend more money to Greece without addressing the fundamental problem of increasing public debt (almost 180% of GDP nowadays versus 146% in 2008), and would require the Greek government to implement further austerity measures that have had, so far, no proven positive economic effects. 

It would ultimately weaken prime minister Alexis Tsipras’ position and increase political risk in Europe. 

Extension of loans' maturity

This is the most likely political compromise in the medium term. It has already been partially implemented since the country will only start paying interest on bilateral loans from 2020 onwards, but this does not yet apply to European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) loans. 

As things stand, Greece is paying interest to its European creditors at a higher level than they have borrowed at. So, by extending its loans' maturity, Greece can regain some leeway without any additional cost to European countries and citizens as long as interest rates to be reimbursed remain higher than the creditors’ cost of refinancing.

Nominal debt haircut

This is the most radical solution, but the most realistic one, considering the economic and financial situation. It would clearly be a mistake to make the Greek debt haircut a particular case.

Sovereign debt restructuring is a more frequent occurrence than is believed. From 1950 to 2010, there were 186 debt exchanges negotiated with financial institutions and bondholders and 447 bilateral agreements with the Paris Club. In the case of Greece, a haircut implies a complete resumption of the debt sustainability calculation that had been carried out by the International Monetary Fund in 2010 and which resulted in a plan to reduce public debt from 175% to 120% of GDP in 2022 by generating a primary budget surplus of at least 3% per year.

There are two main problems with this analysis. First, several recent empirical studies, such as that of Mendoza and Ostry ("International evidence on fiscal solvency: Is fiscal policy responsible?" Journal of Monetary Economics, vol. 55, 2008), conclude that the higher the debt as a percentage of GDP, the more difficult it will be to generate a primary balance that will be sufficient to return to sustainability. As the example of Greece shows, a primary budgetary surplus of more than 3% did not reduce debt as a percentage of GDP and had negative economic impact, such as constraining economic growth.

Second, this analysis does not take into account many macroeconomic factors that are critical to anticipate the debt trajectory, such as inflation and growth. Ultimately, the question is not whether there should be a haircut, but rather whether it is legally possible and how much it should be.

Contrary to what is often mentioned, a nominal debt haircut does not constitute a violation of the non-bailout clause of the Article 125 in the Treaty of Lisbon. In its judgment of March 2011 in the Pringle case, the European Court of Justice clarified the legality of financial assistance between member states to preserve the stability of the euro area as a whole, thereby giving the ESM the green light. If a legal restructuring of the Greek bonds held by the European states is not prohibited, however, the question remains unresolved as regards the bonds held by the European Central Bank (amounting to approximately €27 billion). 

IMF flag
 The IMF target for Greece's debt is set at 120% of GDP. Image: Shutterstock

There are two ways to calculate the scale of a haircut. The first method is to build a static solvency model based on three constants: the nominal interest rate, the real growth rate and the projected primary surplus. The disadvantage of this approach is that it does not take into account any exceptional circumstances, the exchange rate or risks to interest rates in the long term.

Instead, the results should be used as a benchmark in a restructuring process. That is why, in recent years, a second method has been favoured, based on targeting a specific debt threshold as a percentage of GPD. In the case of Greece, the IMF target established at 120% of GDP can be applied, but it is necessary to differentiate the debt that can be restructured (held by European public  creditors) from that which cannot (for instance held by the IMF). 

The calculation is as follows:

Effective haircut = [current debt as % of GDP - target debt threshold as % of GDP] / eligible debt as % of GDP. Based on the participation of European countries and the ECB, an effective haircut of 88% (180-120) / 68 = 0.88 would be necessary to achieve a debt ratio of 120% of GDP. In the event of non-participation by the ECB, the effective haircut would be 100%, which is quite unlikely.

A nominal debt haircut must be conditional on implementation of some key reforms and implemented through the existing international framework known as the Heavily Indebted Poor Countries Initiative, which can be easily adapted to the European context. Since its creation in 1996 (and modification in 1999), it has helped 36 countries, mainly in Africa, which have benefited from debt cancellation of up to 90%. 

Greek PM Alexis Tsipras
 Greek prime minister Alexis Tsipras. How bout a haircut, Alexis? 
Photo: Shutterstock

The last problem raised by a Greek debt haircut concerns the cost to be borne by European creditors. Contrary to what is believed, it would be relatively limited and manageable — all the more so in a context of low interest rates due to the action of central banks and global excess liquidity in the market. Despite monetary tightening in the US, the IMF estimates that central bank liquidity will continue to grow at an annual rate equivalent to 2% of global GDP, before beginning to decline after 2019. As a matter of fact, fear of low liquidity in the market is certainly exaggerated in the medium term.

Moreover, it should be recalled that, in practice, the state reimburses interest on loans, but never the principal. Consequently, the real and immediate cost to European countries would consist of the loss of interest payments made by Greece on loans (1.5% interest on average) and of the cost to refinance loans used to help Athens. The economic cost linked to a nominal debt haircut is quite low compared with the geopolitical effects of the slow collapse of Greece.


— Edited by John Acher

Christopher Dembik is head of macro analysis at Saxo Bank

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