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Expect More Pain for Creditors in a Greek Debt "Extension"



As the International Monetary Fund and World Bank played host to the world's finance ministers and central bankers in October, Dominique Strauss-Kahn was the model of the "activist IMF managing director" when he dared to address a question other Europeans prefer to ignore. What is to be done about Greece's debt problems in the long run, after the current IMF/European Union program runs out in 2012?

By then, the IMF's projections show that Greece will have a debt to GDP ratio of about 145 percent, but it is nonetheless expected to refinance itself at average interest rates of about 5 percent
1—far below today's market rates for Greece. While not impossible, that goal is unlikely to be feasible at normal market conditions. In other words, markets today continue to believe (in a self-fulfilling prophecy) that Greece will ultimately have to restructure or default on its sovereign debt commitments.

Up to now, the Greek government has by and large done what it was asked to do by the IMF/EU in return for their financial assistance. The budget deficit has been reduced, the pension system has been overhauled, state-owned entities have been prepared for privatization, labor markets have been liberalized and product markets have been opened up, most noticeably transportation. In many ways therefore, Greece is now "doing its homework," as Chancellor Angela Merkel of Germany demanded last spring.

But without cheaper refinancing from private market sources in 2012, its efforts will not be enough. The IMF and European Union therefore face a predicament as the deadline approaches. Will they cut their honor student loose, leaving Greece to a fate of trying to roll over its longer-term debt in adverse financial market conditions? That will be politically very problematic.

Since the European Union and IMF have established the precedent of not permitting market-driven disorderly sovereign debt defaults in the eurozone, it is sensible to assume that they will look for an alternative. If there is to be a "second Greek debt crisis game of chicken" as the first program expires, IMF/EU policymakers will likely blink first yet again and authorize additional official sector aid to Greece. To his credit, Dominique Strauss-Kahn signaled as much during the weekend of October 9–10. Referring to what happens beyond 2012, the IMF managing director said that "If the Europeans decide to do something, we certainly will do the same thing," evidently laying the onus of first-to-move on the European Union as the largest financial contributor, but nonetheless clearly suggesting that a program extension is close to inevitable. The response from the German finance ministry—that it is "opposed to an extension of the program repayment schedule"—was predictable, but a subsequent statement that such a discussion is premature suggests that a debate will unfold.

Obviously a great deal of symbolic semantics can be expected in the labeling of this process. An "extension of Greece's payment schedule" certainly sounds better than both "Greek default" and "Greek restructuring." An "extension" implies that the "original still works" but just needs some more time. That is likely to be a politically easier sell to skeptical European publics. Therefore, we should expect that EU and IMF officials will talk only about "extensions" while continuing to deny that any default or restructuring will occur.

This, however, is "political spin." What is evident is that Greece, at the end of the current program, will not be on fiscally sustainable footing. More official sector financial assistance will likely be given to Greece by both the European Union and the IMF.

While the process won't be disorderly, Greek debt owed to the official sector in 2012 will lose worth on a net present value basis, which amounts to a partial default on Greek commitments to the European Union and IMF as they exist today.

The interesting question is therefore at what price public additional support will be given to Greece. Here at least four issues should be recalled.

First, as the Greek government will already have carried out many of the required longer-term structural reforms as part of the first three-year program, presumably boosting Greek economic performance, any conditionality attached to an extension of the Greek program will not be focused to the same degree on structural reforms. Undoubtedly reforms will remain to be carried out, but the Greek economy will have been much better off for having passed its first three-year test, so conditionality will shift elsewhere.

Second, as the first program was negotiated at the height of the eurozone debt crisis in May 2010, at a time of fears of sovereign contagion and spillover effects across the weaker eurozone economies, care was taken to avoid haircuts or losses for holders of Greek debt. The purpose was to avoid undermining market confidence in peripheral eurozone debt. Since then, however, a series of constructive policy measures in eurozone members, most noticeably Spain, will likely lift the risk of market contagion from round two of the Greek debt crisis. The risk to the systemically important eurozone countries (excluding small members like Portugal and Ireland) is likely to be far more limited well into 2011, when this discussion will accelerate.

By mid-2011, EU governments and the IMF may be far less reluctant to impose losses on remaining private holders of Greek sovereign debt than they were in May 2010. As illustrated by the bankruptcy and emergency federal loans for General Motors—which occurred after the height of the financial panic in late 2008—governments are more willing to impose losses on financial participants in times of relative calm. This is likely to prove true in the European Union, too, even if it won't necessarily be pleasant for the two weakest eurozone members, Portugal and Ireland.

Haircuts for private creditors are thus far more likely in the extension of the Greek program than during its formulation. The focus on conditionality will undoubtedly focus on private holders of Greek debt, not the Greek government.

Third, it is worth recalling that in January 2011, the European Central Bank's new haircut schedule for assets eligible for use as collateral in euro-system market operations will begin operating. Unlike the case in May 2010, an operational eurozone framework for applying haircuts to sovereign debt will exist. It would be awkward if a Greek sovereign bond used as collateral with the European Central Bank (ECB) after January 1, 2011, were subject to a haircut, while the same privately held bond could be redeemed outright using EU/IMF funds without any haircut.

Obviously, the precise level of any future haircut on Greek debt in a program extension will have to be carefully negotiated. Here the ECB collateral schedule, which for sovereign bonds (liquidity category 1) with ratings as low as those issued by Greece operates with haircuts between 5.5 and 13.5 percent (depending on coupon and maturity), should probably be regarded as the low-end starting point of such negotiations. Ultimate haircuts are thus likely to be at least as high.

Fourth, recall the German parliamentary debate in May 2010 during which strong voices demanded "bail-ins" of private financial institutions to share the cost with taxpayers. Indeed, the lack of such bail-in was the reason that the Social Democratic Party abstained during the final parliamentary vote, and also the reason why German financial institutions ultimately "volunteered" to maintain their private exposure to Greek debt. German politicians confronted with a "second bailout request" for Greece, in which there is "an extension of the repayment schedule of previously committed public money," will demand that private debt holders are "bailed in."

Moreover, with the German regional state election season starting in March 2011, the current government doing poorly in the polls, and the opposition holding the majority in the Upper House of the German Parliament, it seems highly unlikely that the German government will be willing or able to agree to an extension of the Greek repayment schedule without broad-based support from the political middle. Requirement of such a consensus adds to the logic of haircuts for private debt holders.

In sum, bailout politics will demand that more pain be distributed from a debt repayment "extension," but this time it will hit both the Greek population and the remaining private holders of their debt.


1. See the IMF program review [pdf] of September 2010, table 2. Here the assumption is total Greek government interest expenses of 7.2 percent of GDP for a debt stock of 143.6 percent of GDP. This implies average yields paid of about 5 percent. From Q1 2012, Greece is assumed to roll over 100 percent of its short-term public debt and 75 percent of its medium- and long-term debt. See table 4 [pdf].

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