There is a simple way to resolve the Greek problem that will strengthen the euro, not undermine it, will lead international tax payers to recover the $145 billion they have pledged, not lose it, and will not require ambitious institution building in Europe at a time when the electorate is euro-fatigued. The solution requires three critical ingredients. So far we have seen much of two of them: an onerous Greek stabilisation package and the commitment to a very substantial package of fiscal support to Greece by European countries and the IMF. But doubling and redoubling these will not shock and awe markets into submission while the third ingredient remains missing. No amount of additional flour will make the bread rise if there is no yeast. The missing ingredient is a debt swap that lowers Greece’s interest payments to affordable levels, frees up resources critical to support economic activity and reintroduces market discipline into fiscal policy.
This sounds like a debt restructuring and in essence it is similar, but it is "voluntary" and is not therefore a technical default. There has been much volatility in the price of Greek bonds and much second guessing of bailouts by the market, but in general the price of Greek bonds have fallen to a level discounting a near 50% probability of a default within two years. On a mark-to-market basis, creditors to the Greek government have already lost more than the $145 billion support package. Creditors could be invited to swap old Greek bonds for new bonds whose payments are backed by a European and IMF support package and where the par value of the bonds are the same, but the coupons are considerably lower and the maturities twice as long.
The debt swap is not an alternative to the domestic retrenchment and international support; it is a necessary accompaniment. The precise price and maturity parameters would be so set to ensure that the expected return of creditors in the new bonds with the lower coupon but greater certainty of payout is similar to the older bonds with their highly uncertain prospect of payout. Creditors would not be taking any more of a haircut in the net present value of the bonds than the market has already discounted, but this haircut could cut Greece’s interest bill from 5% of GDP to almost 2.5%. Without a debt swap or a similar move, the decline in the market valuation of the debt to sustainable levels is lost from debtors. Over three years, this reduction in the interest bill would represent half of the fiscal retrenchment required under the IMF program, allowing them to achieve a decline in the fiscal deficit from 13% to 3.5% in three years without cannibalising the economy.
Without a debt swap, but with the unprecedented 16% of GDP fiscal retrenchment proposed by the IMF, Greece’s debt-to-GDP ratio would still rise to 150% by 2013, growth would stall and interest payments on the debt – 70% of which flow overseas – would crowd out all else. The $145 billion package would only have bought peace for a couple of years as a massive resource transfer took place and sustainability questions re-emerged.
In defence of its “no-default plan”, the IMF argues that a debt restructuring in Greece would cause a contagion across Europe. But a debt swap focused on lowering interest payments and preserving the nominal value of the bonds may be less contagious. Net interest payments as a percent of GDP are just 1.1% in Spain, the destination of most spillover concerns. The IMF has considerable expertise in debt swaps and has just managed one of its most successful in Jamaica where 97% of bond holders swapped older, high-coupon bonds for newer, low-coupon bonds, backed by an IMF package of fiscal support and conditionality.
The role of market discipline
In the fog of a financial war, policymakers are easily distracted by enemy flares. In recent weeks, a visitor from Mars might think the problem with Greece was to do with excessive speculation and trigger-happy rating agencies. Ironically, the problem was that speculation and rating downgrades occurred too late. In part, this was due to the markets and agencies disbelieving the “no bailout" commitment between Eurozone member states – and so far they have been proved right. If, however, the lesson of Greece is that while there will be support for members of the Eurozone from other members – they do not walk alone – that support does not preclude everyone sharing the burden of stabilisation, including creditors in a voluntary debt swap. In this case, markets and agencies might be quicker to point out the emergence of unsustainable fiscal positions. I do not kid myself that more market discipline will be sufficient to address all of the euro’s fiscal challenges, but more is necessary and too little contributed to the problem.