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More Jockeying over Greece's Inevitable Haircut



Can we have the euro area crisis and its elevated bond yields back, please?

In the absence of acute market pressure, euro area leaders like Prime Minister Mariano Rajoy of Spain are sitting on their hands rather than opting for stability and applying for aid from the European Stability Mechanism and European Central Bank (ESM/ECB). On Tuesday night, November 21, we saw how—without a market opening deadline early the next morning— a euro group meeting convened to approve Greece's next International Monetary Fund (IMF) loan tranche (to be used in part for bank recapitalization) turned into a session akin to the US Congressional Super Committee. Everyone showed up with their "red lines" and nothing got decided.

For Greece, the bitter irony is that Parliament has accepted the remaining policy conditionality imposed by the Troika—the European Union, the ECB, and the IMF. The impasse results not from hooded anarchists fighting the riot police in Athens, recalcitrant Greek bureaucrats, or even stubborn Greek politicians fearful of hostile voter reactions. Instead Greece's future is being held up by a political fight within the Troika—between the country's two paymasters in the euro area on the one hand, and the IMF on the other.

At stake are two main issues. The first is how to finance the Greek program in the coming years. The second more difficult issue is how to ensure that Greece returns at some point to private market financing.

Earlier euro area decisions gave Greece more time to reach its fiscal deficit targets, but those concessions created a need for another €15 billion in financing by the end of 2014.1 The IMF's Extended Fund Facility (EFF) program that was authorized in March 2012 amounts to 2,159 percent of Greece's quota, an exceptional level of access to IMF resources. Thus the additional funds will probably have to come from the euro area, which has several avenues to close the financing gap. For example, maturity schedules and interest rates for Greek debt held by the euro area can be revised. Such steps would free up cash flow. The ECB's profits from earlier bond market interventions through the Securities Market Program (SMP) can be returned to Greece instead of being held as profits by the ECB's 17 government owners.2 In addition, more money can be allocated to Greece to buy back its own debt at distressed prices, retiring it at a profit. Such bond buybacks rarely lead to an actual decline in the total value of the debt, however, because the price of the remaining outstanding debt goes up. From a financial and net present value (NPV) point of view, debt buybacks therefore often make little sense. But as will be explained below, the euro area needs to focus now on buying time rather than lowering the Greek total debt burden, in order to satisfy the demands of the IMF (at least on paper). Debt buybacks can accomplish that objective even if they don't help Greece.

The tougher challenge is how to ensure that Greece overcomes its economic contraction and become a solvent country with a sustainable long-term debt burden. The IMF's Greek Debt Sustainability Analysis (DSA) of last March stated that its program "remains subject to notable implementation risks" and that "in general, Greece has little if any margin to absorb adverse shocks or program slippages." That grim warning came before the two elections in May and June highlighted Greek unhappiness with the reforms they were told they had to embrace. Greece is today far from achieving the heroic assumptions that projected a decline in the debt ratio to 120 percent of GDP by 2020. That goal was the politically determined threshold for "debt sustainability" and ongoing access to IMF program financing.

So what to do? The IMF itself is in unchartered waters. Its rules for members' exceptional access to funding are tough, but they are designed to protect it against credit risk from defaulting countries. Normally, the IMF would be in a strong position vis-à-vis a government unable to obtain financing anywhere else. If the IMF were the sole determining player of what constitutes sustainable debt levels for Greece, it would simply demand a debt restructuring, with losses imposed on private creditors. The problem is that by any objective metric of the sort used by the IMF—whose membership is made up of countries only—Greece has no prospects of regaining debt sustainability and returning to full private market financing.

But unlike other countries seeking IMF help, Greece is also a member of the euro area, with access to non-IMF financial support from the other euro members. Its insolvency also depends on whether the euro area decides to cut off its financial support—something the euro area has been unwilling to do for its own political and economic reasons.

The IMF is in a bind. Its rules do not take into account the possibility that a program country subject to Fund dictates could also have a backup lifeline from a regional grouping like the euro area. Understandably, the IMF cannot strictly rely on uncertain political promises from the euro area to keep Greece solvent, unless for some reason the IMF Board adopts more flexibility in adopting a credible Debt Sustainability Analysis (DSA) for Greece. Moving toward a more pliable DSA, however, would probably raise questions about the institutional integrity of the IMF, not to mention accusations from emerging markets that Greece was getting special treatment as an "advanced" country.

No doubt Greece and other euro area IMF program recipients enjoy special treatment—Greece by virtue of its highly exceptional access of 2000 percent of its national IMF quotas. But most of that status derives from the generosity of its deep pocketed euro area friends, who have put up twice as much financing for Greece as the IMF. Next time an emerging economy belonging to a regional common market like Mercosur in South America or ASEAN in Asia might well expect a deal like Greece's—provided its neighbors are willing to chip in large amounts of junior capital to any rescue package.

For the IMF, which seeks to remain the preeminent global financial firefighter, playing second fiddle to any other group is not exactly welcome. Yet the Fund is hardly likely to walk away from Greece over a dispute with the euro area. Accordingly, prospects for an agreement between the IMF and the euro area on the debt write-down issue remain good for the next meeting on November 26 . A favorable outlook is enhanced now that Christine Lagarde, the IMF managing director, and the Fund's other top managers, have had a chance to show their independence from the European governments. For its part, the euro area knows that if the IMF walks away, it will have to come up with even more money while losing market credibility in the process.

Germany and other euro area nations increasingly realize that Greece will need an additional write-down of the face value of the sovereign debt held by the euro area governments. For obvious political reasons, they are unwilling to acknowledge this taxpayer liability, even though the Bundesbank president, Jens Weidmann, has publicly stated that accepting a Greek debt write-down will be necessary.

Part of this unwillingness lies in the political timetable in Germany. Chancellor Angela Merkel is loath to acknowledge to her voters that a fiscal transfer to Greece is in the offing. But her hesitancy and the concern of other euro area leaders also results from an obvious moral hazard concern. Granting further debt relief to Greece today undercuts its incentives to fulfill its commitment to reform. It makes logical sense for Greece's creditors to wait until the end of the required reform process before offering debt relief.

In addition, as my late great colleague Michael Mussa said in 2010, it is unwise to decide the size of the haircut imposed on Greece's creditors until you know how big the haircut has to be to restore its access to the markets.3 A successful sovereign (or any other) debt restructuring cannot be carried out in increments. Rather it must be done so thoroughly that the country's debt sustainability becomes unambiguous, so that it never has to go back for more debt relief in the future. That is what the 75 percent NPV haircut accomplished with the privately held parts of the Greek debt last March.

Of course, creditor governments are concerned that an overly generous debt write-down will provoke a taxpayer backlash accusing them of squandering their money on undeserving Greeks. Any euro area politicians will fear bearing the Greeks such gifts. But the reality is that, as my colleague William R. Cline states, no one knows what Greek debt level will return Greece (which is effectively in default) to full market financing. Is it 120 percent of debt to GDP by 2020, as cavalierly assumed by the Troika back in March? Or 100 percent? Maybe 140 percent? Or maybe the 60 percent at which Argentina defaulted in 2001? All we know is that euro governments will have to take a hit at some point.

In March, the IMF's analysis enabled its Board to sign off on the deal to keep Greece afloat. It is an entirely different matter to now ask euro parliaments to determine the hit to be taken by their taxpayers when no one knows whether it will be enough or too much. No euro area parliament is ready for such a proposal now, and euro area governments are wise to hold off on making the request.

Euro area governments have sound political and economic reasons for holding off on granting debt relief until Greece is closer to returning to full private market access. In light of Greece's erratic program implementation so far, they are right to keep its debt on their books until the end of the reform process in maybe 2015. They reason that it is better to wait before deciding on the scale of the losses their taxpayers will have to absorb until more information about Greece's future is available. But make no mistake, a face value write-down of Greek debt held by the euro area is coming, and the IMF is right to nudge the euro area toward the inevitable.


1. The financing gap grows even larger when looking beyond 2014.

2. Note that this round-tripping of ECB profits via the national governments is politically very important, as it marks the difference between monetary financing (if profits were sent to Greece directly by the ECB) and a politically decided fiscal transfer (when ECB profits are redirected to Greece by national governments, after they have received them from the ECB).

3. I am indebted to my colleague Ted Truman for reminding me of Mike's prescient comments.

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