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.