Tuesday, 20 January 2015

Dealing with Greek Debt: Two Lessons from the Past

On Sunday, the Greek will vote a new government. A Syriza victory, and default on Greek public (and private) debt, are in the cards. With increased political uncertainty, the outflow of bank deposits has been massive, once again. Greece’s outlook was revised to negative from stable by Fitch on Jan. 16. Wolfgang Münchau recently has put the case for debt relief forcefully[1]: “In Greece, the political choice is essentially between the status quo of fiscal austerity and an alternative of negotiated debt default. The economic argument for the second course of action is compelling. Greek debt runs at 175 per cent of gross domestic product. The country does not need to service all that debt right now. Greece pays no interest on the “official” debt from the EU until 2023. But this is only eight years away — well within the horizon of any long-term investor. (The first alternative) is a version of extend-and-pretend: extend the loans, and pretend that you are solvent. The history of international debt crises tells us that these strategies are always tried, and always fail.”

Despite various debt reschedulings and haircuts suffered by lenders, Greece´s gross debt stands now at 175% of GDP[2]. Table 1 provides details. Most of the debt was initially held by French and German banks (in that order). Meanwhile, the German taxpayer is the biggest ultimate creditor to Greek debt, indirectly mostly via the EFSF.

Table 1: Greece´ Debt Burden, end 2014

€, bn
%, GDP (€182 bn)

                   Source: FAZ, courtesy Markus Brunnenmaier


Christina Lagarde was quoted (by The Irish Times in an interview released six days ahead of the election) that she reserved judgment on whether Greece´s mountain of debt was sustainable. After several years in office, it is high time she familiarized herself with the IMF Debt Sustainability Framework. For market-access emerging countries (a status which Greece has returned to recently), a gross debt-to-GDP ratio of 70% is considered as a threshold of debt solvency (IMF, 2013, Table 7)[3]. To reach debt sustainability, therefore, even after all the haircuts and rescheduling negotiated over the past years, Greece´s debt would have to be cut by 60% at least.

The past provides two lessons that would militate for immediate debt relief in that size.

First, there is ample precedent within Europe for both debt relief and debt restructuring. Greece´s biggest creditor has repeatedly benefitted from generous debt relief in the past. As pointed out by Benjamin Friedman[4] at a recent BIS conference, Germany has been one of the prominent beneficiaries of debt forgiveness throughout the last century; on multiple occasions, the Western allies had restructured German debt: 1924 (Dawes Plan), 1929 (Young Plan), 1932 (Lausanne Conference) and 1953 (London Debt Conference). Friedman concluded: “There is no economic ground for Germany to be the only European country in modern times to be granted official debt relief on a massive scale and certainly no moral ground either …  The entire (1953) agreement was crafted on the premise that Germany’s actual payments could not be so high as to endanger the short-term welfare of her people … reducing German consumption was not an acceptable way to ensure repayment of the debts. The contrast to both the spirit and the implementation of the approach taken to today’s overly indebted European countries is stark.”

Morally therefore, Syriza follows the right approach by trying to extend the debt relief beyond the insufficient haircut originally agreed upon, which still carries the costs of a default without the benefits of a clean slate. Ex-post solvency counts for much more than manners, procedural details and how the final haircut will achieved. In financial markets, bygones are bygones and, once you have made the point that the default was inevitable, ex-post solvency is what counts.

Second lesson: the curse of defensive lending in the presence of a debt overhang. Defensive lending obliges lenders to refinance themselves the loans when they come due. It can be measured by the extent to which new loans (in gross terms) are explained by debt service of the debt. Cohen, Jacquet & Reisen (2007[5]) have shown for low-income countries, mostly African, the painful decades (especially the 1990s) of defensive lending before the HIPC initiative finally reduced the debt load sufficiently for those HIPC beneficiaries to gain market access: To Forgive is to Forget.

Levy Yeyati (2011) has succinctly stressed that the Greek debt crisis resembles more the 1980 debt crisis in Latin America (“the lost decade”) than the more recent Argentinean debt problems:

“The first approach to the Latin American debt problem was denial. Supposedly, all that was needed was time to implement a drastic fiscal adjustment, for which the International Monetary Fund, sponsored by the United States, would provide the needed refinancing. In 1985, the Baker Plan elaborated on this approach by introducing private sector involvement through the voluntary rescheduling of bank loans, so as to lengthen the fiscal adjustment period. The result was a massive debt overhang that discouraged investment and triggered frequent spells of capital flight and disappointing growth that was reflected in growing debt ratios. This became known as the lost decade for Latin America. Only in the 1990s did the players involved in the debt rescheduling recognize that an insolvent country requires some genuine debt relief, in the form of a reduction in the nominal value of its debt, or a “haircut”. This new understanding took the form of the Brady Plan, which exchanged unrecoverable, unmarketable bank loans for discount marketable Brady bonds – bonds that would be the seed of the emerging markets asset class”.

Again: To Forgive is to Forget.

Historically and now, defensive lending relies on a fiction: the supposed ability of most heavily indebted countries to reduce their obligations over time; it has usually ended in political unrest. In the past, "debt overhang" theories have shown that if there is some likelihood that, in the future, debt will be larger than the country's repayment ability, expected debt-service costs will discourage further domestic and foreign investment and thus harm growth. Potential investors will fear that the more a country produces, the more it will be "taxed" by creditors to service the external debt, and thus they will be less willing to incur costs today for the sake of increased output in the future.

This argument is represented in the debt "Laffer curve" (e.g., Krugman, 1988[6]), which posits that larger debt stocks tend to be associated with lower probabilities of debt repayment. On the upward-sloping or "good" section of the curve, increases in the face value of debt are associated with increases in expected debt repayment, while increases in debt reduce expected debt repayment on the downward-sloping or "bad" section of the curve. Besides confirming this inverted-U relationship between debt and growth, Patillo et al. (2002) have quantified the two critical turning points (for developing countries): the overall contribution of debt to growth appears to become negative at 160-170 percent of exports and 35-40 % of GDP (in net present value terms)[7]. The latter roughly translates to 70% in face value of the Greek debt stock. Unless Greece comes down upfront to a debt stock of maximum 70% of GDP, solvency remains fiction.

Let the Greek vote for Syriza on Sunday. It makes economic sense.

[1] Münchau (2015), Wolfgang Münchau, “Political extremists may be the eurozone’s saviours”, Financial Times, 4/1/15
[2] According to Zettelmeyer et al (2013), “the Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief – over 50 per cent of 2012 GDP – with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors”. See Jeromin Zettelmeyer et al., „Greek debt restructuring“, Economic Policy, 513-563. Zettelmeyer is now the chief economist of Germany´s Ministry of Economics…
[3] IMF (2013), Staff guidance note for public debt sustainability analysis in market-access countries, 9th March.
[4] See Gillian Tett, “A Debt to History?”, Financial Times, 16/1/2015. The file underlying the Friedman speech can be downloaded at www.bis.org/events/conf140626/friedman.pdf; title: “A Predictable Pathology”.
[5] Daniel Cohen, et al. (2007), “Loans or Grants”, CEPR Discussion Papers No. 6024, January.
[6] Paul Krugman (1988), “Financing vs. Forgiving a Debt Overhang”, NBER Working Papers No. 2486, January.
[7] Catherine Patillo et al. (2002), "External Debt and Growth," IMF Working Paper 02/69.

Tuesday, 18 November 2014

AIIB and NDB - Exit and Voice

With hindsight, 2014 may well be noted as the year when serious competition has been built into multilateral development banking, especially for the World Bank and the Asian Development Bank (ADB). The new BRICS bank, officially called the New Development Bank (to be headquartered in Shanghai), has been launched at the sixth summit of the BRICS countries, held in Brazil in July 2014. The bank will have starting capital of US $50 billion, with Brazil, Russia, India, China and South Africa initially contributing US $10 billion. End October 2014, more than twenty Asian countries (including India and, a month later, Indonesia) signed as founding members a Memorandum of Understanding to create the Beijing-based Asian Infrastructure Investment Bank (AIIB), which specified the authorized capital of the AIIB as US $ 50 billion, half of which is paid in by China. Both new institutions are intended to concentrate on funding infrastructure projects.
The recalibration of the world economy (OECD 2010; Quah 2011) - with the centre of gravity shifting toward East Asia – is still not reflected in the executive councils of the multilateral development banks. The current imbalance of capital shares and voting rights in the existing multilateral banking system to the detriment of emerging market and developing countries (EMDCs) is well documented by Vestergaard and Wade (2014) who also show that the scope and pace of governance reforms have been dismal in the established international financial institutions (IFIs). Moreover, the EMDCs can have little hope that the advanced countries relinquish their control on the Asian Development Bank and the World Bank in particular through meaningful voice reform (Vestergaard und Wade 2013).  
The more imbalanced the system is in terms of representation and voice, the higher the pressure to rebalance toward fairer representation through creating institutions parallel to the established multilateral banks. The creation of AIIB and NDB corresponds to exit in Hirschman´s antinomy (Hirschman, 1970). Both exit and voice carry cost. The cost of exit is fragmented multilateralism. The cost of voice in an imbalanced system is the incapacity to influence priorities, principles and procedures in multilateral development lending. As the BRICS nations succeed to organise shadow institutions to the established Bretton Woods system, the value of EMDCs´ exit option may make voice in the established system relatively less attractive, even though it will probably increase the effectiveness of voice. Voice and exit are complements once exit has been organised (by creating new shadow institutions), but are substitutes when seen from the perspective of the initial decision to exercise voice or to organise exit (Gehlbach 2006: 402). Hirschman´s concept of loyalty by a country to the established system (say, to safeguard military protection by the United States) is reflected in a greater cost of exit. That explains why some Asian countries failed to join the AIIB after intense pressure from the US Treasury.
Gehlbach, S. (2006), “A Formal Model of Exit and Voice”, Rationality and Society, 18(4), 395–418. DOI: 10.1177/1043463106070280.
Hirschman, A.O. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Cambridge, MA: Harvard University Press.
OECD (2010), Shifting Wealth, Perspectives on Global Development, Paris: OECD.
Quah, D. (2011), “The Global Economy’s Shifting Centre of Gravity”, Global Policy, 2.1, 3-9 DOI: 10.1111/j.1758-5899.2010.00066.x
Vestergaard, J., and Wade R. H.  (2013), “Protecting Power: How Western States Retain the Dominant Voice in The World Bank’s Governance”, World Development, 46, 153-164.
Vestergaard, J., and Wade R. H.  (2014), “Still in the Woods: Gridlock in the IMF and the World Bank Puts Multilateralism at Risk”, Global Policy, DOI: 10.1111/1758-5899.12178.


Thursday, 30 October 2014

AIIB, NDB and the enforcement mechanism of the Bretton-Woods System

The new BRICS bank, officially called the New Development Bank (NDB, to be headquartered in Shanghai and first to be run by an Indian), has been launched at the sixth summit of the BRICS countries, held in Brazil in July 2014. I hear that it is making relatively slow process. So China has been pursuing recently the creation of yet another multilateral development bank (China-led), the Asian Infrastructure Investment Bank (AIIB), with registered capital planned at $100bn initially double the size of the BRICS bank. By end October 2014, 21 Asian countries – including India – had signed the Memorandum of Understanding on Establishing AIIB. AIIB will be formally established by the end of 2015 and headquartered in Beijing.

The establishment of BRICS-led multilateral development banks (such as the BRICS bank or the AIIB) will be beneficial for global development to the extent that it helps close infrastructure financing gaps and that it helps rebalance representation of the non-OECD countries on the multilateral scene that remains very much US-scripted. The new banks may even speed up ´voice reform´ in the Bretton-Woods institutions – so far effectively hindered despite all rhetoric by the West[1]. However, their very existence makes that reform now less important than in the past when the established MDBs (World Bank, ADB, AfDB, IDB) were the only important sources of infrastructure finance for many poor countries.

In a broader setting, the establishment of multilateral development banks outside the established Bretton-Woods system can be viewed as China´s shadow global diplomacy[2] that aims at undermining US-led governance structures established after WWII. Competition is building for the existing Bretton-Woods system.

So it does not come as a surprise that the US lobbying against those banks.[3] Jane Perlez (2014) cites a senior Obama administration official: the Treasury Department had concluded that the new bank (here the AIIB) would fail to meet environmental standards, procurement requirements and other safeguards adopted by the World Bank and the ADB, including protections intended to prevent the forced removal of vulnerable populations from their lands. By contrast, the ADB has become so encumbered with restrictions that it now takes up to seven years on average for a project to go from proposal to approval to completion, the official said. Consequently, a shift of multilateral lending toward would not only speed up ´voice reform´ but also the financing and building of infrastructure, possibly (not necessarily) at costs for the environment and habitats.

Another concern, not publicly discussed yet to my knowledge, is that the establishment of alternative source of multilateral funding will act to weaken the enforcement mechanism of the existing MDBs. They might as well lose their preferred creditor status[4]. Willem Buiter and Steven Fries (2002) had discussed this after the EBRD had been created: A basic mechanism for fostering compliance with the terms and conditions of MDB loans to the public sector involves the dynamic incentives that arise from the repeated interaction between borrowing governments and the MDBs[5]. The potential for repeated loans, together with the credible threat to cut off future lending when terms and conditions are not met, can be exploited to help ensure borrower compliance. The incentive mechanism arising from repeated interactions is more effective when borrowers face limited access to alternative sources of financing. Therefore, it must indeed be envisaged that the incentive for borrowing countries to comply with the terms and conditions of, say, IDA loans will diminish as the end of the lending relationship nears and is replaced by loans from the AIIB or the BRICS bank.

[1] Vestergaard, J. and R. H. Wade (2013), “Protecting Power: How Western States Retain the Dominant Voice in The World Bank’s Governance”, World Development, Volume 46, June, pp. 153-164.
[2] Rudolf, M., M. Huotari und J. Buckow (2014), „Chinas Schatten-Außenpolitik: Parallelstrukturen fordern die internationale Ordnung heraus“, MERICS China Monitor No. 19, Berlin, 23. September.
[3] Jane Perlez (2014), „U.S. Opposing China’s Answer to World Bank”, The New York Times, 9th October.
[4] The term means that the obligations to MDBs by both sovereign borrowers and private entities have a priority claim and treated as senior to those of bilateral and commercial creditors.
[5]  Buiter, W. and S. Fries (2002), „What Should the Multilateral Development Banks Do?”, EBRD Working Paper No. 74, European Bank for Reconstruction and Development, London, June.

Thursday, 23 October 2014

IS/LM in the Eurozone and Germany´s surplus

The title is a reference to Lance Taylor´s seminal “IS/LM in the Tropics”[1] , the diagrammatic tool stems from Jeffrey Frankel´s paper on optimal sterilization policies in emerging countries, a debate to which I contributed almost a quarter of a century ago[2]. However, quite exceptionally for this blog, this entry is neither on the tropics nor on emerging countries. It is on the dismal zone, better known as Eurozone. The model will illustrate Bundesbank boss Jens Weidmann´s cynical statement about the Euro borrowed from Fisherman´s Friends drops and applied to the Euro: “Ist er zu stark, bist Du zu schwach”[3].

Germany has maintained a large surplus on the current account of its balance of payments – oscillating between six and eight percent of GDP in recent years - although the Eurozone outside Germany weakened, China´s merchandise imports stagnated and other large emerging markets (Russia, Brazil) were in trouble. As demonstrated by Patrick Artus´ team at Natixis Economic Research, the German surplus can be explained neither by a drop in its domestic demand (as is often done) nor by improved terms of trade. It is largely due to improved market shares and trade balances with the United States, Japan, non-euro-zone Europe and China, which has offset the deterioration in its trade position in the euro zone. As will be shown below, Germany´s hyper competitiveness slows down the depreciation of the Euro, required by the rest of the Eurozone to make it a bit less dismal.

IS/LM in the Eurozone

The Eurozone is illustrated by the familiar textbook macroeconomic general-equilibrium model, with the IS, LM, and BP curves denoting goods market, money market and balance of payments equilibrium, respectively. Demand for output Y is shown on the horizontal axis, with the price level predetermined in the short run. A move to the right on the y-axis thus denotes only employment gains (and no inflationary pressure), a move to the left employment losses. Y is the sum of domestic aggregate demand and the trade balance (net foreign demand for domestic output). The interest rate i is presented on the vertical axis; as the Eurozone has open capital markets, the interest rate i is equal to i*, the international rate. The overall balance of payments, BP, the sum of the trade balance and the capital account, is horizontal: the capital account rules, the current account follows, and a rise in i above i* sucks in infinite capital inflows (as long as the Eurozone is still ´investible´).
Germany´s surplus is so huge that it translates into a surplus of the Eurozone. The IS curve shifts to the right as the trade balance improves, putting upward pressure on the interest rate and therefore on the capital account. As the Euro is a flexible currency (outside the Eurozone), money inflows (not trade) will appreciate the Euro. In the model, the currency will appreciate far enough to return the trade balance, the IS curve, and domestic aggregate demand back to point A. In plain words, Germany´s improved trade balance has to be ´paid´ by even more depressed demand in the rest of the Eurozone. Maybe, Jens Weidmann should have said: “Is Germany too strong, it should abstain from using the Euro”?

[1] Lance Taylor (1981), „IS/LM in the Tropics: Diagrammatics of the New Structuralist Macro Critique”, Economic Stabilization in Developing Countries, Vol 502, Brookings Institution, Washington DC.
[2] Jeffrey Frankel (1997), „Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?“, Estudios de Economía, Vol. 24.2, December, pp. 263-285.
[3] Interview Jens Weidmann „Ist er zu stark, bist Du zu schwach“,  in Süddeutsche Zeitung, 22.5.2014; see http://www.bundesbank.de/Redaktion/DE/Interviews/2014_05_22_weidmann_sz.html