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)
|
|
Public
|
|
243
|
133.5
|
|
|
EFSF
|
142
|
|
|
|
IMF
|
24
|
|
|
|
ECB
|
27
|
|
|
|
Bilateral
|
53
|
|
|
Private
|
|
74
|
40.6
|
|
Total
|
|
317
|
174.1
|
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.
