Europe’s Greece problem, which brought the euro area to the brink of a breakup in 2015, is back in the headlines. And so, too, is the issue of whether Greece can succeed without more debt relief—an issue on which European officials remain at loggerheads with the International Monetary Fund (IMF) and among each other. In a new PIIE working paper, Eike Kreplin, Ugo Panizza, and I show that Greece will indeed need such relief, and discuss how it could be delivered. The good news is that this includes options within the political and legal red lines drawn by European finance ministers last year, which rule out outright debt forgiveness. The bad news is that these options will nonetheless raise formidable political challenges, as they imply that, in one way or another, Greece will owe debt to its European partners for a very long time. Indeed, under some options, Greece’s official debts would rise substantially before they fall again.
Greece has gone through several rounds of official debt relief since 2011, most recently in January of this year, when European creditors approved a set of measures to smooth Greece’s repayment profile, reduce interest rate risk and waive a planned interest rate increase on a portion of its debt. The question whether Greece requires additional debt relief—and if so, how much—was not supposed be decided by the Eurogroup (the group of euro area finance ministers) until 2018, the last year of the current program. But in the meantime, some European countries, led by Germany, have insisted that the IMF rejoin the ongoing program as a condition for the next disbursement to Greece. The IMF, in turn, has tied this to two conditions: agreement on a package of fiscal and reform measures that goes well beyond what Greece had signed up to with the Europeans in August of 2015, and a European commitment on sufficient official debt relief.
In a report released on February 7, 2017, the IMF argued that Greece’s debt is “highly unsustainable” and called for deep debt relief involving all official creditors but itself. Two days later, Klaus Regling, the managing director of the European Stability Mechanism (ESM), responded that if Greece fully implemented its ESM-supported reform program, debt sustainability could be “within reach,” and that in any case, Greece’s euro area partners had pledged additional debt relief at the end of the ESM program, should there be a need for it. If anything, these two statements understate the underlying disagreements. While European institutions, including the ESM, have long advocated some degree of additional debt relief for Greece, a number of creditor countries, led by Germany, remain unconvinced. German Finance Minister Wolfgang Schäuble has repeatedly stated that if only Greece undertook meaningful structural reform, it would not need debt relief.
Who is right? Our paper seeks to provide an indepth answer based on state-of-the-art debt sustainability analysis and an empirical analysis of the international experience with protracted fiscal adjustment. We arrive at three main results.
First, Greece does indeed need extra debt relief, and quite a lot of it. While one can write down fiscal adjustment and growth assumptions that would make Greece’s debts sustainable, Greece is not likely to conform to these assumptions. Under any scenario that is consistent with typical—rather than exceptional—advanced and emerging-market country behavior in the past, Greece will need more debt relief.
Second, the measures that Greece’s European partners have said they would consider when deciding whether to grant debt relief could in fact be enough to deliver the debt relief needed—but only if they are taken to an extreme. In particular, Greece would likely require both extensive maturity extensions and interest deferrals relating to its €131 billion debt to the European Financial Stability Fund (EFSF), the ESM’s precursor. The interest deferrals imply that Greece’s debts to the EFSF would be growing for a protracted time in the range of €100 billion or more for several decades before they start declining. This would be very difficult for the European creditor countries to accept.
Third, there are possible solutions to this dilemma. They include extending debt relief to other types of official debt, such as the €53 billion “Greek loan facility,” a vehicle based on bilateral euro area government loans to Greece used in Greece’s initial 2010 bailout. Another approach would be to attempt to reduce the EFSF’s long-term funding costs, with the savings passed on to Greece under euro area rules, through operations that attempt to lock in today’s low interest rates.
Yet another approach would be to combine the debt relief measures envisaged by the Eurogroup, except for EFSF interest deferrals, with continued financing of Greece through the ESM. From the perspective of both saving Greece money and reducing the scale of required debt relief, this approach would make a lot of sense, as it would avoid borrowing from the private sector at a time when doing so is still very expensive for Greece. But it would also require a fourth, and possibly fifth, sixth, and seventh ESM program, for which there is very little appetite both in Greece and in the Eurogroup.
To summarize, Greece’s debt problem can be solved. Not only can it be solved, but it can be solved within the broad political and legal red lines laid out in last year’s Eurogroup statement, namely, that “nominal haircuts are excluded, and that all measures taken will be in line with existing EU law and the ESM and EFSF legal frameworks.” But finding an adequate solution will still be politically very difficult, and it may require considering options beyond the measures that the Eurogroup has publicly put on the table so far.