Debt relief would correct a mistake

Austerity and reform fatigue as well as several years of economic recession cast doubts on the success of the new bailout program to be agreed between Greece and its lenders in the coming weeks. Official debt restructuring will take some political pressure off the government but it will have to translate into even lower primary budget surpluses than currently offered to make a difference. Still, it could reduce implementation risks at a time when the political landscape is changing, increasing the chances of keeping Greece in the euro.

As expected, Parliament voted for the first package of measures, including value-added tax and pension reform, last week. This opened the way for the bridge financing to pay off International Monetary Fund arrears and the European Central Bank on time and the initiation of talks for the European Stability Mechanism (ESM) program.

It is expected to pass another set of legislation by Wednesday, including the transposition of the Bank Recovery and Resolution Directive (BRRD) into Greek legislation, and more in the next few weeks to allow for more disbursements under the bridge financing and the conclusion of the new program.

The agreement on Greece reached at the eurozone summit refers to the potential for official sector debt restructuring along the lines of the Eurogroup deal on November 2012. Given that the ESM requires a debt sustainability analysis be conducted, and the IMF’s continuing demands for debt relief due to the worsened debt profile, an official sector initiative (OSI) becomes more likely. This will help the government sell the new package more easily to its rank-and-file as well as the greater Greek public.

Of course, debt relief is subject to Greece delivering on its commitments by the conclusion of the first review of the ESM program. This is likely to take place after September. But this conditional debt relief will not take the form of haircuts on the notional amount of Greek debt, but loan and bond maturities and interest rate amendments.

The focus of the debt sustainability analysis may not be on the public debt-to-GDP ratio this time around but on the country’s gross financing needs, as some analysts have pointed out.

It is reminded Greece’s public debt is made up of about 15 billion euros in treasury bills and about 27 billion euros in bonds held by the Eurosystem, namely the ECB and the national central banks before the 3.5-billion-euro repayment this week. About 184 billion euros is due to eurozone countries, of which about 131 billion is owed to the European Financial Stability Facility (EFSF). Loans from the IMF should be 20 billion euros or less prior to the expected repayment of the 1.6-billion-euro tranche in arrears. The state has also borrowed 10 billion euros or more from state entities via short-term repurchase agreements (repo).

Greece’s privately held bond debt is estimated at around 13 percent of total public debt. It mainly comprises PSI bonds issues in the debt restructuring in 2012, about 29.6 billion euros and 6.1 billion euros of three- and five-year bonds issued in 2014. There are also holdouts from international law bonds worth 2.6 billion.

It should be noted that the bonds have been issued under English law and any modification in the terms of the bonds would need to be approved by a two-third majority at a bondholders’ meeting.

Bankers say no large privately held redemption is due until July 2017, when 2.1 billion euros is due.

There is no doubt the country will pay dearly for the confidence gap created over the last six months or so between the Greek authorities and the lenders.

A development which many observers easily attribute to former Finance Minister Yanis Varoufakis, although he is not the only one responsible. The eurozone summit has already precipitated political change. The cabinet has been reshuffled and the coalition government of SYRIZA with Independent Greeks (ANEL) has effectively lost its majority in Parliament. Already, some ministers and high-level SYRIZA party officials are hinting at or talking openly about snap elections in the fall after the ESM program has been finalized.

In this political context, the strict conditionality and monitoring of the new program and the economy’s return to recession after a brief lull, political pressure on Premier Tsipras and the government will grow as time goes by. It is also likely that new anti-euro political groups or parties may emerge. Perhaps the only tangible thing mainstream parties offer to the public to justify a new three-year program is lower primary surpluses ahead.

The lenders have offered downward revised targets equal to 1 percent of GDP in 2015, 2 percent in 2016, 3 percent in 2017 and 3.5 percent in 2018. Under normal economic conditions, targets below 3 percent of GDP can be regarded as feasible. But these times are not normal. Therefore, the targets should be lowered even more. However, the latter cannot be done without substantial debt relief. With the ECB and the IMF on board and the ESM calling for debt sustainability, there is fertile ground for taking action.

Of course, Greek debt relief will not be an easy sell in some eurozone countries like Germany. However, a case can be made that the benefits of debt relief are bigger than the costs. Moreover, this way, the lenders can correct a mistake they made in designing the first bailout in May 2010 when they opted for more conditional loans rather than debt restructuring and less demanding primary surpluses, undermining the program with excessive austerity.