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On Greece, Growth, and Downgrades



Events remain unsettled in the euro area in 2012 in spite of some recent progress toward stabilizing the fiscal and financial outlook. To begin with, negotiations between the Greek government and private creditors represented by the Institute for International Finance (IIF) have been suspended as they enter the final critical phase, with each side considering their final "red lines" before the EU Summit on January 30, 2012.

The Struggle over Debt Restructuring

As always in such negotiations, the impasse is over who gets stuck with a bill that keeps getting bigger as the Greek domestic economy deteriorates. Last October, it was evident that the first 20 percent debt write-down negotiated the previous July would not deliver debt sustainability for Greece. Accordingly, the haircut on the debt principal was raised to 50 percent. Today, it seems obvious that while the 50 percent reduction in debt principal remains sacrosanct, the reduction in the net present value (NPV) of privately owned Greek debt will have to exceed 50 percent if Greece is to achieve debt sustainability. Moreover, private investors must participate in the "voluntary bond swap" at essentially 100 percent to reach that goal, according to the International Monetary Fund (IMF).

That is unsurprisingly proving to be a tough circle to square. As more investors oppose the "voluntary transaction," the lower the bond coupon (e.g., lower NPV) for the new Greek debt becomes. Investors then become more likely to take their chances in an "involuntary bond restructuring" triggering sovereign credit default swaps (CDS). Financially, it comes down to the price of Greek debt that private investors paid or value on their books, as well as the price and payout of potential CDS protection and the NPV of the new replacement Greek bonds. Politically, however, for the Greek government and the euro area, the threat of "Greek contagion" will decide the outcome.

Currently markets seem to expect a voluntary deal between the IIF and the Greek government. I tend to support this view. In the end, a lower coupon on new bonds will be acceptable for the IIF, provided there is sufficient security and "upside participation" in the new bonds. The new bonds, for example, could be governed by the United Kingdom rather than Greek domestic law, preventing the Greek parliament from changing the rules in the future. There could also be a GDP-linked coupon, permitting a higher payment for investors in the future if the Greek economy recovers from its current slump. Another incentive for the deal is the potentially significant hidden cost to the entire euro area from a Greek default.

Yet, this outcome is not guaranteed. For one thing, while it may be the Greek government that is negotiating, in the end it is the euro area that will decide! Euro area leaders will thus establish the price they are willing to pay to avoid an involuntary restructuring resulting from a default and an unknown potential for fresh contagion. The IMF has been clear in its demands that the euro area make up for any financial shortfall from the Greek bond swap.

Assume that the IIF accepts a deal that leaves Greece €30 billion short of an estimated target for debt sustainability, for example. Such a deal would require the euro area official sector to contribute to financing Greece in the future. Euro leaders would also take into account their estimate of the scale of any market contagion to sovereign bonds issued by Ireland, Portugal, Spain, and Italy and the debt held by euro area banks. If you believe that the European Central Bank's new three-year Long-Term Refinancing Operation (LTRO) is more than adequate to shore up euro area banks, and that new reform measures announced by Prime Minister Mario Monti of Italy and Spanish Premier Mariano Rajoy are adequate, and that Ireland and Portugal will continue to adhere to their current IMF programs, then that €30 billion is not worth paying.

On the other hand, it is clear that a coercive restructuring of Greece would have other costs to the euro area. Much is being written about the unfairness of the European Central Bank (ECB) not participating in any restructuring of the Greek debt it holds, as private debt holders are doing. This argument is patent nonsense, as it overlooks the ECB's role as part of the official sector participating in the Greek bailout in ways that the private sector does not.1 But there are valid questions regarding the ECB holdings of Greek bonds, as the bank is currently the single largest individual holding of an estimated roughly €45 billion.

Whatever happens, the ECB itself will not take any financial losses from an involuntary restructuring. Instead, any losses will be borne by the owners of the ECB, namely euro area governments. The ECB Governing Council will surely and successfully demand to be made whole in the name of safeguarding its institutional independence. Since the July 21, 2011 agreement , in which the ECB first secured credit guarantees from the euro area governments to enable acceptance of Greek collateral in its repo transactions, it has been clear that the ECB is a politically senior Greek creditor to the euro area governments and the European Financial Stability Facility (EFSF).

Because of the retroactive writing of coercive collective action clauses into all Greek government bonds, an involuntary Greek restructuring could legally force the restructuring of ECB holdings of Greek sovereign bonds. This restructuring would take the form of the Greek bonds being swapped at par (or at the ECB purchasing price) with new EFSF bonds. The arrangement would transfer the entire financial loss from any euro area official holdings of Greek sovereign debt on to the EFSF, leaving the ECB's balance sheet intact. Such a swap of perhaps €45 billion of ECB-owned bonds could easily cost the EFSF two-thirds of the original sum, or €30 billion.

Such a transaction would amount to a backdoor recapitalization of the ECB. But the process through which it occurs will matter tremendously in political and policymaking terms. Simply put, Chancellor Angela Merkel of Germany would prefer the political poison of an ECB-EFSF bond swap over the political outcry in Germany from a required direct recapitalization of the ECB after a Greek default, which would quite likely require a separate approval of the Bundestag.

Losses from insolvent countries will therefore be borne by the euro area fiscal authorities, rather than the monetary ones. Without ironclad assurances and the removal of impaired assets before losses are recognized, the ECB would likely become more hesitant in assisting illiquid euro area members in the future.

An ECB-EFSF swap of Greek bonds in danger of default would send a powerful signal to private sector investors in other euro area debt markets. Such investors might fear the precedent effect on Spanish and Italian bond markets derived from the ECB enjoying an IMF-like super-preferred creditor status protecting it from losses in a Greek restructuring. Private investors might also fear that as the ECB increases bond purchases, the remaining private sector investors will become more and more subordinated as creditors. Ironically, the result might lead them to demand higher interest rates as ECB holdings expand.

Such fears, however, are misguided. They stem from erroneous and oversimplified market assumptions by private investors that protecting the ECB from direct credit losses leaves only private investors to suffer losses. The institutional setup in Europe is more complicated. The ECB is not a lonely island unto itself. It is one of several European official sector institutions with different capacities to absorb credit losses. Since late 2010, when the first stealth fiscal transfer was granted to Greece in the form of aligning its higher interest rates and shorter maturities with the lower terms offered to Ireland in return for Greek compliance on austerity, the EFSF has been able to take NPV losses on loans ahead of private investors. Outright credit losses on Greek government bonds would certainly be politically trickier for the EFSF than under-the-radar concessions to Greece. Such a strategy would make it harder to argue that support for Greece is a one-off. Faced with the alternative of inflicting direct credit losses on the ECB, something under the radar would be feasible, however.

On the other hand, these concerns over how the euro area official sector "socializes" its credit losses is frankly secondary. What matters is the precedent of the EFSF (and its successor, the European Stabilization Mechanism (ESM), which comes into being later this year) taking credit losses pari passu with (if not ahead of) the private sector, even if the ECB itself is protected.

Another potential hidden cost for the euro area from an involuntary restructuring of Greek debt is the weakening of assurances that Greece is indeed a unique case. There will probably have to be an explicit financial commitment beyond the existing political commitment to "continue providing support to all countries under programs until they have regained market access, provided they fully implement those [IMF] programs." (This assurance has applied to Ireland and Portugal.) If Greek debt is coercively restructured, markets are unlikely to take such rhetorical commitments at face value. To regain market access, Ireland and Portugal might require new de facto fiscal transfers, perhaps in the form of a refinancing of high-yield Irish National Asset Management Agency (NAMA) bank bailout notes with lower cost EFSF debt. Ironically, Ireland and Portugal could thereby benefit from an involuntary Greek default.

All these considerations add up to the conclusion that a last-minute accord between Greece and its private creditors looks likely to be reached. But a bond swap deal would not guarantee a newly revised IMF program with Athens. A much more important obstacle is the newly indicated inability of Greece's new unity government led by Prime Minister Lucas Papademos to implement any meaningful part of Greece's structural reform program. This reform vacuum was severely criticized in the latest IMF program review . Without a dramatic change in the political gridlock in Athens, an imminent bond swap deal with private creditors may only postpone an inevitable Greek economic collapse by a few months. A new revised IMF program would be impossible to negotiate in the face of continued Greek non-delivery of required reforms.

A delayed Greek collapse would have different implications for the rest of the euro area. The consequence of a deal with a 60 percent or more haircut for creditors, and new bonds governed by English law, would effectively eliminate the private sector as creditors to Greece. Greece would essentially become a euro area domestic problem, a complete ward of the state/euro area for all practical purposes. The IMF would remain the preferred official sector creditor. In that scenario, any private sector contagion from a subsequent Greek domestic economic collapse could be less acute, since most private financial losses will already have been allocated.

Contagion risks from Greece could well subside following a deal on debt restructuring, eliminating any real leverage Greece has vs. its euro area partners. A deal with private creditors is only the first, and arguably the easiest, political hurdle ahead for Athens. As the odds grow smaller for contagion from a Greek meltdown after such a deal, Athens's ability to extract political concessions from the euro area diminish. In this scenario, Greece might find itself at the mercy of euro area hardliners seeking to protect themselves and the EFSF—with little regard for what happens to the Greek economy (or to Greek citizens). If a debt restructuring deal is implemented with the private sector creditors and Greece still does not deliver on structural reforms, notions of European solidarity will truly be tested. Ultimately, the political question will be asked in the euro area: can the common currency have a member that remains unwilling or incapable of economic reform?

Standard and Poor's Roils the Water

The other main recent event in Europe was the downgrade of the sovereign debts of several euro area countries and the EFSF in early January. Unlike a potentially imminent coercive Greek restructuring, however, the rating action was largely anticipated and had little impact on market prices. Indeed, it is easily established from looking at market prices of debt and sovereign CDS rates that the new S&P ratings merely reflect existing market realities. The agency, for example, simply bowed to the reality that euro area countries whose 10-year bonds trade more than 100 basis points above AAA-rated Germany cannot themselves be AAA rated.

It is possible, however, that the downgrade of Portugal to grade BB will cause its bonds to lose liquidity as they are dropped from various industrialized country/investment grade sovereign bond indices. (Cyprus may also suffer in this way.) Like other ratings that might affect the size of ECB haircuts or the status of downgraded bonds as repo collateral, the Portugal downgrade indicates nothing about the informational value of the rating. Instead, markets movements merely reflect their own dysfunctional reliance on credit ratings in many standard financial contracts and regulations. This is true even though the two other large credit rating agencies, Moody's and Fitch, have not followed S&P's actions.

The principal effect of the downgrading action will therefore be political rather than financial. The biggest unknown is likely to be the impact on the French presidential election. The loss of AAA status for France could be a serious blow to President Nicolas Sarkozy, but French voters may on the other hand take the loss of the top rating as a sign of the seriousness of the plight of France. If economic credibility subsequently becomes a theme in the election, it might strengthen Sarkozy and weaken the Socialists, with their baggage of favoring a 35-hour work week and retirement at 60 years of age now being carried by the party's candidate, François Hollande.

A closer look at S&P's justification for its downgrade betrays a stereotypical view of the euro area political economy—and, for a credit rating agency, a surprisingly cavalier attitude to the political sequencing of economic policymaking. The key explanations offered by S&P are the following:

Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone's financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone's core and the so-called "periphery." As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers' rising concerns about job security and disposable incomes, eroding national tax revenues.

The relevant sequence in the first paragraph is the second, which mentions that market price signals have already moved and that S&P ratings need to catch up. The last paragraph is most revealing of the analytical capacity of S&P. Few will dispute the dangers of fiscal profligacy. But since the beginning of the global financial crisis, external deficits in peripheral countries (except for latecomer Italy) have declined while Germany's current account surplus is basically flat. Therefore it cannot be said that euro area external imbalances are rising.2

Then there is the claim that the euro area reform process is "based on a pillar of fiscal austerity alone." This assertion is blatantly misleading. It ignores the structural reform progress (admittedly disappointing in Greece) under way across the periphery, which will generate growth in the longer term if implemented successfully. Without significant structural reform progress, the lack of peripheral competitiveness cannot be credibly addressed inside a common currency.

Initial ECB and European Commission support for the bizarre doctrine of expansionary fiscal consolidation—the idea that crisis stricken governments can cut the fiscal deficit without any adverse effects on growth—has fortunately disappeared in the face of overwhelming empirical evidence. But the question remains as to whether a similar fallacy exists (and can surprisingly be discerned in the S&P explanation) on the other side of the European austerity-vs.-stimulus debate. That would be the fallacy of asserting the existence of a "consolidating fiscal expansion," i.e., the idea that indebted governments can stimulate growth without any adverse effects on the debt-to-GDP ratio.

It is important here to differentiate between the experiences of United States, with its overhang of debt now a political issue in the presidential campaign, and those of most European countries. Everyone is understandably in favor of more growth. But unlike the United States, Europe faces growth impediments that are overwhelmingly structural in nature. In the United States, more and properly structured stimulus spending (not just tax cuts for the rich) might well spur sustainable economic growth, such steps are less likely to be effective in most European countries in the absence of liberalizing labor and product markets and the role of euro area institutions. Germany's opposition to fiscal stimulus can be debated. But it is much less likely that stimulus spending will produce a sustainable burst of growth in Italy, France, or Spain without such a regulatory overhaul.

As Premier Monti of Italy points out, the euro area must pursue a path towards a more fiscally integrated euro area before any introduction of eurobonds is considered. But austerity in the euro area has been unavoidable and should not be reversed until the peripheral and euro area institutional structural reforms agenda is further progressed. The simple European political economy fact is that such reforms are politically the toughest thing to implement. Contrary to what S&P states, euro area austerity is neither "a lone pillar" or "self-defeating." It must come with a necessary shift in policy.

Fortunately, the S&P downgrade of the EFSF looks unlikely to increase the cost of its raising capital for Greece, Ireland, and Portugal. Indeed an AA+ rated EFSF looks likely to be able to raise capital on basically the same terms—e.g., trading roughly at the level of France—as an AAA-rated EFSF until it is replaced by the ESM as early as June 2012.

Since the ESM will likely be an AAA-rated entity because of its paid-up capital structure (making it less reliant on sovereign guarantees), a lower rated EFSF might even have a better political chance of being kept alive alongside the ESM after June 2012. Euro area leaders might then have a new political option to expand its financial bailout vehicles in the name of increasing "policy flexibility." They could do so by deploying both AAA and slightly lower rated bailout vehicles at their disposal. Such an EFSF existing alongside the €500 billion ESM might well be scaled back from its current €440 billion capacity for political reasons, reducing the size of EFSF guarantees proportionally granted by all euro area members in the process. If a smaller EFSF were nonetheless allowed to coexist with the AAA-rated ESM, their partnership would amount to progress in establishing a credible and sufficiently sized euro area firewall.


1. The expansion of the ECB balance sheet, continued acceptance of Greek collateral, etc. comes to mind, just as the ongoing concessionary lending to Greece by euro area governments for years to come does.

2. It is obvious that continuing if declining deficits adds up to increasingly negative external stocks, but adopting the line that net external investment positions cannot continue to rise in the short-term is akin to stating that even Latvian style shock therapy is too tepid.

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