What will happen to Greek debt?

Source: extranea.wordpress.com

It would appear that all of a sudden, the question of what will become of the Greek debt (currently at 170% of the country's GDP) has arisen. While everyone seemingly had forgotten about it over the past couple of months when the Troika negotiations had been going on, now long talks and negotiations between the IMF and the EU are taking place to settle this issue.

German Finance Minister Wolfgang Schäuble is strongly opposing IMF chief Christine Lagarde who proposes that Germany and other creditors forgive a portion of Greece's debt in order for it to become sustainable. Such a development would mean that Germany's fears about not being able to protect the German taxpayer, with whose money they have financed Greek deficits, would materialize in the worst possible way. From what we can read, Schäuble will propose that a solution for reducing the debt levels would be for the Greek government to buy back 50% of the remaining private sector debt at a 25% of its value. This would mean that if a bank or any other investor had bought Greek bonds of €100, after last year's haircut the bonds are only worth €21. Under Schäuble's plan, the investor would essentially sell the bonds for approximately €5. This would essentially mean that 50% of the investors would lose approximately 95% of their invested money. (Nevertheless, as it appears that this piece of news only appeared in Greek media, I would have serious thoughts about its validity)

Yet, as a compromise has not been reached yet, the question remains: how will the Greek debt be reduced to bearable levels? There are only two simple solutions which come to my mind:

1. Interest payments for the outstanding public debt should be paused for a period of 5 years. 

This would allow Greece to use its primary surplus to finance its current needs as well as repay a portion of the current debt load. The Greek statistical service reports that the country will need to repay approximately €55 billion of debt in the next 5 years; giving it the opportunity not to pay any interest rates in the next 5 years would mean that Greece could return to growth in 2014-2015 and then make it easier for the nation to cover its loans. This way, the German taxpayer (or any other taxpayer in the EU) does not have to worry about losing her money; she would just receive less profit on the amount loaned.

2. The ECB should directly fund any financial needs Greece has from now on.

By doing this, it would mean that no taxpayer in any country will be worried about her government losing her hard-worked money due to Greece. By having the ECB fund the debt, the country would have to pay much less interest rates than otherwise, and this would lead to an opportunity for a quicker repayment of debt.

Solution 1 is actually easier to be implemented than solution 2, with the added advantage that it will bring results much sooner than its alternatives. Given that the prerequisite for countries to approve of a solution is that they will not lose any money of those they have invested so far, they should take this into serious consideration.

Greek debt revisited

Over the last days, new publication concerning the state of Greek debt have been published by the rating agencies. Specifically, both Moody's and Fitch expect this year's recession to reach 7%, next year's about 3% and 2014's will be practically zero. Public debt is expected to reach 180% in 2014 as well, with unemployment rates soaring to 22.8% by the end of the year. Alas, it seems like troubles will never end for this country!

In addition, a German magazine, stating anonymous source within the Eurozone, has stated that another Greek haircut is being considered. (for details, click here). According to the same source, at the same time, the IMF proposes a plan which promotes debt restructuring for the public lenders, which hold about 2/3 of the now €330 billion Greek debt. So, by simple math, if debt is 164.9% of GDP now, Greek GDP has to be around €200 billion. This would mean that if the new plan proposes restructuring the debt until it reaches about 120% of current GDP, no less than €90 billion euros will disappear into thin air!

Need I ask which of the now ailing governments would be willing to take such losses? Obviously none. Very few nations in the EU have the resources to handle this. Even more, extending the Greek debt by 2 years will have an additional €20 billion cost for Greece's lenders. 

Some of the regular readers (hmm I may be flattering myself!) of this blog may recall, I have already proposed that the Greek austerity and reforms program should be extended by 1 year and not by 2. Why is that? Simply because a two-year horizon would allow the Greeks to be more lax, than a 1-year one. While benefits of an extension are obvious, the truth is that over-extending the austerity program is bound to some incentive problems. Although I believe that Samaras is the best politician the Greeks have had for many years, his popularity has started to fall, given the perpetuation of the Troika talks concerning the €11.9 billion austerity measures, as well as the measures themselves.

Thus, what other alternative is there? What the IMF proposes, although a nice idea, would be difficult to implement especially given the current circumstances. What needs to be done is shift focus from austerity to growth. The reason why the Greek debt is growing as a percentage of GDP is because the latter is diminishing at a fast pace. Debt can be haircutted a million times and still not be sustainable if GDP keeps becoming lesser and lesser. The solution lies not in reducing the debt, but in increasing the GDP.

The European Investment Bank has recently agreed to facilitate Greece with a package of €750 million over the next few months, aiming at energy, transport, education and SME's. This money should be distributed to Greece as soon as possible and put to good use. This kind of stimulus package should be able to promote some growth in the country's economy during this and the following year. In addition, measures promoting growth should exist on the 2013 fiscal budget; measures which would actually promote growth not merely social benefits and other transfers. 

Once focus is shifted from austerity to growth and GDP moves from decreasing to increasing, more austerity meausres should be promoted to keep costs down. In the opposite case, 1 or even 2 extra haircuts may be needed in the not-so-distant future.

Greece's Progress

Many are always accusing the Greeks for the situation their country currently faces and their lack of action for the persistence of financial problems. However, a recent IMF study begs to differ:

As you many see from the above table (it is also in page 93 of the IMF study) Greece's primary deficit is expected to be 1% of GDP this year (i.e. 2012), move to an 1.8% surplus in 2013 and having surpluses until 2030. This would mean that over the next years, Greece will essentially be paying its existing debts, without having any deficits other than the repayments! Gross refinancing needs will drop from 34 billion to 14 billion over the next year meaning that it will essentially take much less money to refinance debt. 

However, the need for debt restructuring may occur, as it is expected to reach 167% of GDP this year. At least this time, I hope that the troika decides better than hair-cutting the debt again! (for an alternative solution to the Greek haircut read this). The Greeks have suffered through severe austerity measures too rapidly, which forced the country's GDP to contract vastly and that is why the debt burden as a percentage of GDP has increased so rapidly (allow me to explain. If debt is 100 and GDP is 100 then debt is 100% of GDP. If the GDP contracts - as is the case with Greece - to 80 then the debt would be 125% of GDP)

The 2.5 billion they are currently requesting is nothing compared to another haircut (or worse a default) which would make financial markets (and especially banking institutions) even more chaotic. European leaders seem like impatient children, who want to see debt reduction and positive growth from one moment to the next instead of thinking that such a procedure requires much more time.