Brinkmanship in Brussels, Sturm and Drachma for Greece and Europe

Just as it did when Congress recently extended the payroll tax cut, brinkmanship has produced an early-morning deal in Europe to extend a new lifeline to Greece and clear the way for the biggest sovereign bond restructuring in history. Both pieces of the agreement – the privately held Greek debt write-down of more than €100 billion and the terms of the new bailout extension – have produced widespread doubts in markets and among many analysts. Accordingly, a more detailed look at both is worthwhile, before considering how this package fits into the ongoing brinkmanship between the Eurozone and the IMF and the general focus on austerity in the Eurozone.

The Greek deal

The agreement on the privately held debt write-down – known as private-sector involvement, or PSI – is no ordinary bond swap, but instead a remarkably complex transaction of unprecedented scale. The ultimate haircut accepted by the private creditors from the Institute for International Finance went up to 53.5% of the principal bond value. Factoring in estimated average reduced coupon payments of new bonds of just 2.63% in the first eight years and 3.65% of the full 30-year period1, the ultimate net present-value loss for private creditors looks likely to approach 75%–80%.

The new Greek bonds will be governed by English law, which means that the Greek government will not in the future be able to change the regulation of them. They will also be explicitly treated equally (pari passu) with new official-sector loans from the European Financial Stability Facility as part of a co-financing assistance package to Greece. These sweeteners notwithstanding, it remains the case that private creditors face dramatic financial losses as a result of this bond swap.

An important technical aspect of this proposed swap is the proposed issuance of new securities linked to the future GDP of Greece. Investors could see this as an increase in bond payments if future Greek growth exceeds currently anticipated levels. This type of bond was used in Argentina after its default and has provided investors with good returns as the Argentinean economy rebounded. The critical question remains what future Greek GDP growth will be. If current GDP growth projections are very low, then there is a reasonably certain future gain for private creditors, although such payouts are capped at “an amount of up to 1% of their notional amount” beginning in 2015, according to the Greek Finance Ministry (2012). Figure 1 shows the projected Greek real GDP growth rates (from 2011–20) in the baseline scenario in the most recent IMF debt sustainability analysis.

Figure 1. Greek real GDP growth in percent per annum (DSA baseline scenario)

Source: Greece: Preliminary Debt Sustainability Analysis (DSA), Table 1. Dated 15 February 2012.

Many commentators are likely to dismiss the probability of Greece exiting its recession in 2013 or achieving a 2.3% growth rate as early as 2014. As we shall see below, such fears are likely well founded. But in a ‘baseline scenario’ where another Greek default is not assumed, one must heed what my late great colleague and forecaster extraordinaire Mike Mussa (2009) called the Zarnowitz Rule: “Deep recessions are typically followed by steep recoveries”.

According to the IMF estimates, Greece will suffer a cumulative decline in real GDP of about 16% from 2009–12, taking the country to near Latvian recession levels. By any definition, that is a ‘deep recession’. According to the Zarnowitz Rule – named after Victor Zarnowitz, a University of Chicago economics professor who studied business cycles – the projected Greek GDP growth rates after 2013 are extremely conservative, assuming that Greece implements its new IMF reform programme. The prospect of Greece not experiencing any noticeable cyclical rebound looks highly implausible in my opinion. So why has the IMF assumed such low future growth rates in its relatively benign baseline scenario?

The IMF may just be extremely wary about Greek growth prospects, which would be understandable. But its caution on growth rates from 2013 to 2020 could also be part of an attempt by the troika (the ECB, the European Commission, and the IMF) to ‘sweeten the deal’ by ensuring that any GDP-linked securities will pay out a bit more generously if Greece avoids another default. This prospect could therefore entice more private creditors to sign up for the swap. Eurozone leaders would then get the political benefit today of ‘scalping’ private creditors, knowing that the actual payouts could increase in the future.

Will private creditors participate in this ‘private-sector involvement’ agreement voluntarily, given the huge losses entailed? No doubt most will, in part because they are subject to ‘moral suasion’ from their own governments, particularly Greece itself when it comes to Greek domestic banks. But it remains an open question whether there will be enough participation from other private holders, including global hedge funds, to ensure a sufficiently large amount of Greece’s outstanding privately held debt is voluntarily swapped to sufficiently reduce Greece’s total debt burden. The alternative is quite clear, as the Greek government has – with the blessing of the Eurozone and the IMF – already moved to introduce retroactive collective action clauses in its outstanding bonds to force holders of Greek law bonds to participate in the ‘voluntary’ swap. The legal route to a coercive restructuring process is thus straightforward. But a coercive restructuring would transform the Greek bond swap into a ‘credit event’, triggering credit default swap contracts.

At this point, however, it is doubtful that doing a coercive Greek restructuring would make a material difference to Greece or the Eurozone credit markets. Yes, a forced restructuring would trigger credit default swaps. But in today’s world of three-year long-term refinancing operations by the ECB, most of Europe’s banks have realised the majority of Greek bond losses and limited their gross credit default swap exposures (which are spread among many individual banks2), and would probably not suffer major disruptions. No major European bank faces collapse from Greek credit default swaps. Indeed, actually triggering credit default swaps on a net present-value loss on a sovereign bond of around 75% might be preferable to avoid the material impairment of the entire industrialised sovereign credit default swap market. After all, after such a ‘voluntary’ Greek bond swap, who would believe that any sovereign contract on an OECD country would be worth anything? This could ultimately end up hurting legitimate hedging opportunities across sovereign bond markets. In short, it is difficult to see any explanations other than Eurozone political pride for the extraordinary lengths to which European officials have gone to secure a ‘voluntary’ bond swap.

A more interesting question concerns the fact that this deal affects only private creditors while excluding the entire official sector, eg the IMF, the ECB, and Eurozone governments. Does this arrangement set a new precedent subordinating private-sector creditors as junior to the official sector in the Eurozone? If so, potential contagion to other Eurozone sovereign bond markets would seem plausible. One could thus question how the Institute for International Finance could sign on to such a degrading of their status?

The danger of such contagion is far from evident, however. This Greek deal does not necessarily set a precedent for the rest of Europe. The Eurozone has already declared Greece a unique case, not to be repeated elsewhere. More important, the Eurozone bond market contagion effects after the first deal was announced in July have abated. Italian and Spanish bond yields are at levels before July, indicating at least some market acceptance. Thus concerns that this week’s deal will enshrine private-creditor junior status in the Eurozone appear misguided.

Such is especially the case if Greece cannot ultimately meet its IMF reform commitments and faces a second default down the road. A second post-deal default would overwhelmingly affect the official sector, since the remaining private sector debt will be highly difficult to restructure under English law. In practical terms, because the IMF is the super-senior creditor, a second Greek default would impose losses predominantly against the other Eurozone countries. In other words, the current deal merely ensures that severe losses are imposed on private creditors a few months ahead of potentially severe losses for the Eurozone official sector.

Put against such a counterfactual of an ‘inevitable second Greek default,’ it may well have been wise of the Institute for International Finance to have accepted the de facto ‘two stage Greek default deal’ (first against the private sector and then against the official sector) that was on the table this week and ensure that its private members at least secured new Greek bonds under English law for a part of their original claims. In a hypothetical politically very messy unstructured ‘single event’ Greek default, where losses would have been imposed on both the private and official sector simultaneously, it seems probable that the Institute for International Finance membership could have faced a consequence even worse than the perhaps 75% loss they suffered this week.

Greece’s new IMF deal

The other part of the deal struck in Brussels concerns a successor IMF programme for Greece for at least three years. This new programme is premised on Athens’s “legal implementation by Greece of the agreed prior actions” (European Council 2012a). There is, for example, a further list of things the Greek parliament must pass in the coming weeks. (The second premise is a successful bond swap reducing Greece’s total debt burden.) Considerable uncertainty remains about whether this successor IMF programme will ever get off the ground. It looks likely that implementation will take place ahead of Greece’s large bond redemption on 20 March, however.

The aim of Greece’s new IMF programme is to reduce Athens’ estimated debt-to-GDP ratio in 2020 to the target of 120.5%. It is important to remember, however, that debt and GDP projections eight years into the future are illusory. Such long-term projections are highly dependent on various assumptions. Any eight-year target must be considered a political benchmark, underscoring the fact that it will be up to the troika to judge whether it has been met.

The Eurozone governments engaged in a series of financial-engineering transactions with the ECB and national central banks to help reach this target. As predicted earlier, the ECB itself will not directly have to take any losses on its Greek bond holdings. But the owners of the ECB – Eurozone governments – have instead agreed to channel some of the ECB’s profits towards Greek debt relief. As they put it, “certain government revenues that emanate from the SMP [Securities Market Program] profits disbursed by NCBs [national central banks] may be allocated by Member States to further improve the sustainability of Greece’s public debt.”

This statement refers to a complex and circular financial flow, in which the Eurozone governments will first pay Greece some of its bailout funds, then Greece will pay off the ECB’s bonds with this money. Then the ECB pays its profits back to its owners, the Eurozone governments, which can then grant these funds as debt relief to Greece. The benefits are wholly political, as the arrangement relieves the ECB from direct bond losses. Yet the deal enables the ECB to contribute indirectly to Greek debt sustainability through profits redistributed according to the ECB capital ownership key. This would in theory be done in a manner that Mario Draghi, the ECB president, says does not constitute “monetary financing” (ECB 2012). National central banks will engage in essentially similar circular transactions.

Of broader significance is the Eurozone agreement for “an additional retroactive lowering of the interest rates of the Greek Loan Facility so that the margin amounts to 150 basis points” (European Council 2012a). Such a ‘stealth fiscal transfer’ will further reduce Greek interest payments and lower the total debt burden. Moreover, the Eurozone willingness to continue to trim interest rate costs for Greece suggests that further ‘stealth measures’ may be extended to Ireland and Portugal.

The new IMF debt sustainability analysis makes clear that there are real concerns over the prospects for Greek programme implementation. The analysis states that Greece’s “debt trajectory is extremely sensitive to programme delays, suggesting that the programme could be accident prone, and calling into question sustainability.” Put another way, Greek debt sustainability will not be achieved unless Greek compliance improves materially from the record of omissions and delays since May 2010. Opinion polls suggesting that far-left populist political parties will make gains in the elections due in April, raising doubts about the ability of any new Greek government to implement its commitments (Rueters 2012).

To ensure greater compliance, some new efforts are under way to install an “enhanced and permanent [troika] presence on the ground in Greece” (European Council 2012a). Similarly, the separate ‘escrow account’ for Greece will be implemented, as discussed in an earlier post, to “put in place a mechanism that allows better tracing and monitoring of the official borrowing and internally-generated funds destined to service Greece’s debt by, under monitoring of the troika, paying an amount corresponding to the coming quarter’s debt service directly to a segregated account of Greece’s paying agent.” In other words, from now on the troika can pay off Greece’s bondholders and withhold funds to the Greek government. Greece’s acceptance of the escrow account was possibly the biggest surrender of fiscal sovereignty by any industrialised country in recent history. It reflected the great political lengths Greek leaders are willing to go to avoid an economic default.

Ultimately, however, nothing in the latest developments changes my prediction from early February (Kirkegaard 2012) that the key ‘Eurozone political risk’ in 2012 remains what to do if Greece turns out to be beyond reform. It seems probable that any new Greek government will get only a brief programme honeymoon. If Greece continues its poor record of implementation, the troika can cut off further bailout funds as soon as a new ‘Eurozone firewall’ with an operational European Stability Mechanism and more capital for the IMF are in place around July. Such a cutoff would set up a potential second Greek default as early as the late summer of this year. The Greek government would then have to decide whether to remain in the Eurozone. Greece would not likely be kicked out, but a voluntary self-initiated exit would probably be accepted.

It is finally difficult not to interpret the tenor and focus of the latest IMF analysis as almost an invitation to the IMF and its major European shareholders to cut off further funds to Greece. The IMF’s non-European shareholders will for reasons of regional resources allocation likely welcome such a step. The IMF staff, of course, will be rightly concerned about the institutional integrity of the IMF in the face of political pressure to give Greece a pass. If the fund were seen to be giving Greece preferential treatment, it would unleash demands for similar leniency from future programme recipients around the world.

Brinkmanship between the Eurozone and the IMF

Since December, the EU Council and the IMF have jockeyed over who must pay the bill for a new European financial firewall. Such ‘burden-sharing’ was the intent of the Eurozone’s commitment to provide the IMF with about $200 billion in new capital, provided that other members also contribute perhaps $300 billion. Half a trillion dollars in new IMF capital is a lasting global good that would stabilise the Eurozone. Consequently and appropriately, other major G20 members have signalled a willingness to provide the IMF with additional new capital, if the Eurozone does more to save itself. As I have discussed earlier, I continue to believe that EU leaders will agree to increase the European Stability Mechanism to €750 billion at their next summit in early March to accommodate these demands.

At the press conference after the Eurogroup meeting, at which IMF managing director Christine Lagarde also participated, this view was once again reiterated. A possible European Stability Mechanism increase was “considered but not concluded” at that meeting. But Lagarde also invoked brinkmanship yet again in discussing the potential scale of the IMF’s participation. German finance minister Wolfgang Schäuble mentioned at his press conference that perhaps the fund would contribute an additional €13 billion, plus the remaining €10 billion from the first programme, for a total of €23 billion, though this would be subject to the final approval of the IMF Board (European Council 2012b).

A potential contribution of ‘only’ €23 billion out of a total new programme financing need of €130 billion would equal 18%, considerably less than the hitherto implemented one-third/two-thirds split between the IMF and the Eurozone. But an important caveat must be kept in mind. The €130 billion total includes several idiosyncratic components, with which IMF contributors will not participate. (These include the costs associated with providing European Financial Stability Facility financial support for the Greek deal and associated bank recapitalisations, and projected future Greek European Stability Mechanism contributions.) Stripping the new Greek IMF programme of ‘Eurozone-specific financing items’, elevates the €23 billion IMF contribution to the traditional participation level of about a third of the total.

Lagarde fired a little-noticed warning shot, however, when she stated that “the IMF board will have in mind the overall program but also additional matters such as the proper setting up of a decent firewall comprising of European Financial Stability Facility and European Stability Mechanism as considered today, but not concluded today” (European Council 2012c) She also made it clear that the IMF Board would decide on its contribution only in the second week of March after the next EU Summit.

In other words, unless EU leaders agree to increase the European Stability Mechanism, other G20 members will likely not contribute more money and the IMF Board might even decide to reduce the fund’s participation in the future, forcing the Eurozone governments to make up the shortfall. Exercising brinkmanship in her own fashion, Lagarde presented a choice to EU leaders and Chancellor Angela Merkel of Germany in particular. Pour more money into the European Stability Mechanism in early March or be forced to pour them into Greece later.

No doubt EU leaders will choose the former.

Austerity in the Eurozone

The deteriorating situation in Greece is frequently cited as an example of the adverse economic impact of Europe’s insistence on austerity. Athens is alleged to be an example of a wrong-headed European crisis response, with its tough new Fiscal Pact and other rules to enhance surveillance and budgetary discipline within the common area membership. This critique, however, is only partly deserved. It ironically suffers from the same fetishist preoccupation with austerity that it criticises.

No doubt austerity hurts short-term growth prospects and the doctrine of ‘expansionary consolidation’ is a politically expedient myth without empirical foundation. But short-term austerity is not the only economic and political problem troubling Greece or the rest of the European periphery. Each crisis-stricken economy (as well as most of the rest of the Eurozone, noticeably France) faces its own idiosyncratic and complex structural barriers to growth. The Eurozone’s short-term growth picture and outlook (-0.3% real GDP growth in Q4 2011) is not great, but the real growth disaster for Europe is the continent’s low long-term potential growth rate, for which estimates since the beginning of the global financial crisis have fallen below 1%. That is less than half the estimated potential growth rate before the crisis began (Eurostat 2012).3 Substantial empirical uncertainty surrounds such estimates, yet without far-reaching structural reforms, the Eurozone crisis will pose a long-term threat to the potential growth rate of the Eurozone economy far greater than the short-term slump of the next several quarters.

In the ideal world, farsighted policymakers could simultaneously pursue short growth through fiscal stimulus and structurally overhaul their economy for the long-term and restore fiscal sustainability when growth returns. But such a political feat is impossible in a crisis with the unprecedented fiscal and banking turmoil in the Eurozone today. Elected leaders have a finite agenda at any one moment and must consequently sequence their responses.

Ultimately the right policy emphasis will vary from economy to economy. For the US, which continues to suffer from a cyclical downturn, more short-term economic stimulus is warranted. Again in an ideal world, Congress would pay for such stimulus (and other federal government spending programmes and defence) in a sustainable manner.

The Eurozone periphery is in a different situation, however. Current estimated trend GDP growth rates in the five countries are less than 1%.4 Spain will never see sustained job growth with its current labour market laws. Other Eurozone countries with average effective retirement ages of around 60,5 or the majority of workers protected from adjustments to their work rules and conditions, will never regain competitiveness without change. Indeed absent such structural reforms, new fiscal stimulus in the Eurozone periphery will be a waste.

Proponents of steps to reflate the Eurozone periphery miss the critical political economy point. Structural reforms are the most politically difficult steps to implement for incumbent governments. They are adopted by parliaments only when all other options are exhausted. As the Eurozone crisis illustrates, the boundaries of what is politically possible are expanded only when the pressure is most acute. Fiscally stimulating these troubled economies before appropriate structural reforms are implemented would be a mistake.

Some paint current Eurozone austerity as needlessly flagellating medicine meted out by a moralistic ‘pain caucus’. They overlook the fact that the Eurozone is finally embarking on critically important structural reforms. Spain’s labour markets are being reformed, and Italy’s closed services sectors are finally seeing some sunlight.

This sequencing is not an accident. Neither Spain nor Italy would be undertaking reform without accepting austerity first. The austerity measures were a necessary political evil on the road to the hardest structural adjustments. The fact that progress is under way across almost all the periphery is among the best news coming out of Europe. These steps forward have consigned Greece to the role of an inglorious outlier, deserving of more blame for its failure to implement structural changes than for missing its deficit targets. On the other hand, it is important to give some ‘policy space’ to countries undertaking reform, enabling them to fall short of their deficit targets if they are embarking on a healthy long-term political agenda. It would not be responsible to punish such hard-won successes in these countries.

Fortunately, Europe’s new Fiscal Compact has more than enough political room to grant genuine Eurozone structural reformers some leniency on reaching deficit targets. The troika and the European Commission for non-IMF programme countries must use that latitude responsibly. A country that has implemented the structural components of its IMF programme for instance should always be considered to be in ‘political compliance’ with its programme, irrespective of whether it misses its annual deficit target by a little bit.

Prime Minister Mario Monti is right that an Italy that has now embarked on a serious set of structural reforms should not implement additional austerity measures. It would be madness if the European Commission were to insist that the Spanish government – busy with overhauling its labour markets and banking system – meet its 4.4% of GDP deficit target for 2012.

Credible structural reformers in Italy, Spain, and Portugal should be granted the benefit of the doubt on their 2012 deficits by the IMF and – especially – the European Commission. Otherwise, Europe’s fiscal surveillance framework will not have progressed during this crisis.

Editor’s note: This was first posted on Peterson Institute’s Realtime Economics.

References

European Central Bank (2011) “Monthly Bulletin”, January.

European Central Bank (2012a), “Introductory statement to the press conference (with Q&A)”, press conference with Mario Draghi and Vítor Constâncio, 9 February.

European Council (2012a), “Eurogroup statement”, press release, 21 February.

European Council (2012b), “ECONFIN Council – February 2012. National Briefing: Germany – Part 2”, press conference with Wolfgang Schäuble, 21 February.

European Council (2012c), “Eurogroup – press conference”, 21 February.

Eurostat (2012), “Euro area and EU27 GDP down by 0.3%”, press release, 15 February.

Greek Finance Ministry (2012), Press release, 24 February.

Kirkegaard, Jacob Funk (2012), “How Euro Brinkmanship Is Beginning To Succeed”, blogpost, Peterson Institute for International Economics, 3 February.

Mussa, Mike (2009) “Global Economic Prospects as of September 2009: Onward to Global Recovery”, presented at the 16th semiannual meeting on Global Economic Prospects, 17 September, Peterson Institute for International Economics.

Reuters (2012), “Greeks want euro but downbeat on future – polls”, 19 Feburary.

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1 All data from the Steering Committee of the Private Creditor-Investor Committee for Greece Press Release “Common Understanding Reached on Key Terms of a Voluntary Exchange of Privately Held Greek Government Bonds (GGB’s),” dated February 21, 2012.

2 See the detailed data from the latest EBA stress tests [zip 1.5mb] from December 2011 for bank-by-bank gross CDS exposures in the Eurozone.

3 See ECB (2011).

4 See European Commission AMECO Database table 6.6.

5 The standard OECD measure for average effective age of retirement is available here and is calculated as a weighted average of (net) withdrawals from the labour market at different ages over a 5-year period for workers initially aged 40 and over. In order to abstract from compositional effects in the age structure of the population, labour force withdrawals are estimated based on changes in labour force participation rates rather than labour force levels. These changes are calculated for each (synthetic) cohort divided into 5-year age groups.