“The European Union finally agrees a bail-out, and the much-predicted rally of Greek bonds turns into a rout. A week later, spreads on Greek bonds had reached their highest levels since the outbreak of the crisis. The financial markets have recognised that, bail-out or no bail-out, Greece is in effect broke.
The bail-out prevents a default this year, but makes no difference whatsoever to the likelihood of a subsequent default. Just do the maths: Greece has a debt-to-gross domestic product ratio of 125 per cent. Greece needs to raise around €50bn ($68bn, £44bn) in finance for each of the next five years to roll over existing debt and pay interest. That adds up to approximately €250bn, or about 100 per cent of Greek annual GDP.
In 2010, the Greek economy will contract, on the most credible estimates, by between 3 and 5 per cent. Inflation will fall towards zero, so nominal growth will also contract sharply. Nominal GDP will probably contract even more sharply in 2011, and will continue to contract, perhaps at a slower rate, in 2012 and the following years. The reason for the persistent contraction in nominal GDP is that Greece needs to turn a primary deficit of more than 7 per cent into a primary surplus – before interest payments – of at least 5 per cent, a turnround of more than 12 percentage points, while at the same time improving its competitiveness through wage cuts. The latter implies deflation. As the Greek economy goes through the adjustment process, the debt-to-GDP ratio will deteriorate towards 150 per cent or so.
To avoid long-run insolvency, Greece will need to find a way to stabilise the debt-to-GDP ratio. This would in turn require a multi-annual deficit reduction plan and a programme of structural reforms to raise the potential growth rate. The Greek government has so far presented a one-year plan to cut the deficit from 13 per cent of GDP to about 8.5 per cent. While this sounds ambitious, it is not very credible, as it is based heavily on tax increases, with no structural reforms.
But even if the Greek government were to present a credible long-term stability plan, the risk of default would remain high. This means that some form of debt restructuring is unavoidable. Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late 1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt is converted into long-term debt. This would push the significant debt rollover costs to well beyond the adjustment period.
One way to force the debate would be to attach super-senior status to the EU loan to Greece. I understand this is still an unresolved issue. Super-senior means this loan would be repaid before existing debt. Should Greece ever get into a liquidity squeeze, bondholders would be put in a back seat. In such a situation, they might prefer rescheduling.
I would also expect the International Monetary Fund, which is co-financing the EU rescue package, to take a much broader look at the Greek situation than the EU. The IMF will probably demand a much bigger overall adjustment effort on the part of Greece. In turn, I suspect the IMF would take a hard look at the question of restructuring or rescheduling. On my calculations, we have already gone beyond the point of no return, and should no longer focus on whether we can avoid default but on how best to manage it. Will it be an orderly process, or are we looking at default of the messy Argentinian kind?
Greek bondholders are not prepared for a haircut. Even though Greek bond spreads have risen to over 400 basis points last week, they are still not reflecting the real risks involved here. Two weeks ago, many readers were puzzled at my assertion that a 300 basis point spread implied a 17 per cent probability of a 17 per cent loss. I merely, and lazily, took the square root of 300, rounded down, and arrived at one plausible combination, amid an infinite number of possibilities. A similar calculation implies that a 400 basis point spread, as of last week, would be consistent with 20 per cent probability of a 20 per cent loss.
The best thing you can say about the rescue package is that it buys time to negotiate an orderly default. Restructuring and rescheduling is probably the only chance for both Greece and its bondholders to come out of this mess still standing.”
munchau@eurointelligence.com
Moral hazard