Greece's debt tragedy - the need for official sector writedowns

By:
Euromoney Skew, Sid Verma
Published on:

Default, massive buybacks or official-sector writedowns are needed for Greece to reach any reasonable level of debt sustainability. The 120% debt-to-GDP target by 2020 is wide of the mark.

Possibly the worst-kept secret in global markets: Greece won’t be able to cap its debt-to-GDP ratio to 120% by 2020, raising the ugly spectre of default or eventual exit from the eurozone. Although the failure to reach the elusive 120% target is a long-held view among economists, European policymakers now grudgingly accept this reality, though they dispute the exact level of Greece’s projected debt pile in the years ahead.

What a farce. As Charles Dallara, head of the Institute of International Finance (IIF), told us earlier this year, Angela Merkel, German chancellor, the-then French president Nicolas Sarkozy and Christine Lagarde, IMF managing director, were united in the historic Greek debt restructuring in October 2011: private-sector losses should help to stabilize Greece’s debt burden to 120% of GDP, they said at the time.

Instead, Dallara, who was in charge of co-ordinating private-sector creditors in his capacity as head of the IIF, argued that this target shouldn’t serve as a dogmatic benchmark to calculate the necessary private-sector-held debt losses but, rather, should influence Greek reforms and a rescue package over a medium-term economic cycle. 

In the end, both Dallara and eurozone policymakers claimed victory, after the €100 billion debt reduction for Greece was facilitated, with Merkel et al stating Greece’s 120% debt-to-GDP target was on track, stoking tensions with the IMF.

However, eurozone policymakers for years have been living in cuckoo-land. All private-sector economists and market players have long argued the troika has factored in delusional growth assumptions for their politically expedient debt targets. Although Greece has approved yet another package of austerity measures, insolvency still looms large without urgent redress. The IMF and European Commission are at loggerheads over the precise debt burden come 2020, from 175% of GDP at present to a projected 190% next year, but the European Commission is sticking with its 146% projection.

Now fears are growing that eurozone policymakers will fail to disburse Greece’s next loan tranche when they meet next week. The bailout package, agreed in March, is under threat amid frustration over the country’s slow pace of economic reform. There is some speculation that the IMF will withdraw from the bailout if there is no feasible plan to materially reduce Greece’s medium-term debt burden, with the Fund being criticized in recent years for its timidity. Accordingly, despite a slew of bailouts and debt writedowns in recent years, the jury is out on which prospect is most likely: the official sector seeking new ways of nurturing a sustainable medium- to long-term debt burden for Greece, or the country leaving the eurozone.

The clock is ticking. A €5 billion three-month T-bill is due on November 16, with the European Central Bank (ECB) resisting pressure to roll this over, though the hope is the Bank of Greece will find a solution via the emerging liquidity assistance facility, with implicit ECB support. The consensus is that the eurozone wants to avoid a technical default so it will be averted.

No matter. Greece needs a massive debt writedown – fast. The ECB has stated it can’t take any principal writedowns on Greek holdings since this would constitute monetary financing, and at this week's press conference, president Mario Draghi made it clear the central bank was running out of options in propping up Greece. The ECB can transfer any profits to national central banks – and has previously – though that is expected to help only at the margin. The IMF is pressuring eurozone countries to take a haircut on bailout funds disbursed so far, but that's proving too contentious.

The tragi-comedy is expected to continue. No private sector economist reckons Athens can meet its target, and Merkel is looking to kick the can further down the road by delaying any Bundestag vote on Greece's austerity package until after the September 2013 German elections.

Accordingly, this chart is not for the light-hearted:



According to Barclays Capital, for the 120% target to be reached, a stock debt adjustment of more than €100 billion would be needed.

Amid this mess, here are a couple of options, some more controversial than others, mooted by Commerzbank: 

Deducting bank aid from national debt

The debt-to-GDP ratio could also be reduced via direct ESM [European Stability Mechanism] recapitalization of Greek banks. In this case, these would no longer be included in national debt. Under the second bailout package, €48 billion are earmarked for the recapitalization of Greek banks of which as much as €15 billion were already paid with the first tranche. If the remaining €33 billion were directly transferred  to Greek banks via the ESM, Greece’s debt-to-GDP ratio would be lowered by 16 percentage points.
 
However, Germany, the Netherlands and Finland are opposing direct bank aid through the ESM, as long as a joint eurozone banking authority is not yet in place. And even after its establishment, the ESM shall not be held liable for inherited debt. Thus, this back door is closed.

Reduce interest rates on bailout loans
 
The IMF cannot grant Greece special conditions. The EFSF, however, might reduce the premium on its own refinancing costs by 50 basis points. This would result in annual relief of €724 million for  the Greek budget. In turn, this would push the debt ratio down by almost three points by 2020. In such a scenario, interest rates for Ireland and Portugal would probably have to be adjusted as well. The EMU countries have already reduced interest rates on their loans to 3%, ie considerably below the peripherals’ refinancing costs. If the core countries slash their interest rates by another 100bp, the interest burden for Greece would decline by €174 million per year. In short, another interest-rate cut would not be of much use. Still, we would not exclude such a step completely.

Debt buy-back
Greek government bonds are currently trading considerably below their notional value. The  Greek minister of finance could reduce the debt load by a buy-back of outstanding bonds. At the moment, private creditors hold Greek government bonds with a notional value of €67 bilion. These bonds are currently trading at an average discount of 74%. If half of the creditors were willing to sell their bonds at a discount of 70%, Greek government debt would be reduced by more than €23 billion. However, that works only if the Greek minister of finance can get cheap funds for a buy-back. We could imagine that the European Stability Mechanism (ESM) might provide the necessary €10 billion. In that case, however, public-sector creditors would hold almost 80% of Greek government debt.

Stricter medium-term targets
In return for permitting higher deficits in 2013 and 2014, the troika might demand that Greece generate a budget surplus in the medium term. This solution would be attractive for policymakers because it will not cost anything. However, it would only shift problems down the road, seeing that the Greek minister of finance is to generate a primary budget surplus of 4.7% of GDP from 2017. Greece has not come even near such a surplus in the past 12 years. And privatization receipts are highly unlikely to surprise to the upside, as the country is already far behind on its privatization targets.


Bottom line: even if interest rates are cut and Greece is given a two-year extension, most analysts reckon a Grexit risk is huge. Instead, a combination of the measures, including a debt buy-back programme and an extension of debt targets, is expected, if official sector writedowns remain a taboo.

But both a debt buyback program and the transfer of Greek government bonds to the ESM combined would only facilitate an estimated €26.7 billion debt-relief, rather than the necessary €100 billion to meet the 120% debt-to-GDP nirvana, according to Barclays Capital. Analysts in a report said:

"Buyback – Possibly the most effective option in the very near term. ..., assuming that the ESM disburses EUR20bn for the buyback, Greece may achieve c.EUR20bn of stock debt reduction (net). Total debt currently held by the private sector amounts to c.EUR63bn. Assuming an average trading price of 50 (following a buyback announcement and against current trading price of between 22 and 32).

Although this option has been discussed recently, it seems to have become less likely due to the opposition of Northern Europe to commit to additional loans by the ESM or EFSF.

Transfer of GGBs holdings from the ECB to the ESM :

By selling GGBs holdings to the ESM at book value, the ECB may accelerate the process of using (expected) trading profits to lower the stock of debt. Assuming a book value of 85 and that GGBs’ holdings at the ECB probably amount to c.EUR45bn (SMP programme + its Investment portfolio), we estimate that the stock of debt could be further reduced by c.EUR6.7bn. It should be noted that timing implementation is crucial. In fact, most of ECB bonds will mature before 2015 meaning that a restructuring of these bonds can only have a substantial impact if carried out in the next year or two. Moreover, it is worth noting here that additional debt relief could be achieved by further restructuring those bonds."


In other words, default, massive buybacks or official-sector writedown are needed to reach any reasonable level of debt sustainability.