Athens may not need a debt haircut

How unsustainable are Greece’s borrowings? This question has moved center-stage after the eurozone agreed on August 14 to lend Athens up to 86 billion euros in a new bailout program.

The eurozone is keen that the International Monetary Fund also lends money in the bailout. But the IMF thinks Greece’s debt is unsustainable and won’t provide more loans unless the eurozone gives Athens relief on its existing borrowings. The snag is several eurozone countries, including Germany, are reluctant to cut the debt burden.

This isn’t something that ought to scupper the deal. The eurozone has agreed to proceed without the IMF, in the hope that it will join in later. It will consider debt relief after the first review of the new bailout, which could be as soon as October. But it won’t agree to a haircut on the face value of the debt.

So there should be a basis for an agreement. This would involve giving Greece longer both before it starts repaying its debt and before it needs to finish the job. But the devil will be in the detail, in particular over how to measure debt sustainability.

Various approaches

The traditional approach, looking at debt-to-GDP ratios, is not suitable for Greece because its borrowings are mostly on concessionary terms. The eurozone loans already have long grace and repayment periods, as well as extremely low interest rates. A crude debt-to-GDP ratio – which, in Greece’s case, is expected by both the eurozone and IMF to peak at about 200 percent – doesn’t take any account of these benefits.

An alternative would be to look at the present value of Athens’s debt – what its total future debt payments are worth in today’s money. The European Stability Mechanism, the eurozone’s bailout fund, says that all the concessions so far given to Greece have reduced the present value by the equivalent of 49 percent of GDP. If one subtracted that from the headline ratio – assuming, for simplicity, that all the other debt is kept at face value – Greece would be left with 150 percent of GDP.

One can also calculate the present value of the new 86-billion-euro loans, which will pay interest at only 1 percent and have an average maturity of 32.5 years. The present value of that loan is around half its face value.

By giving Athens such generous terms, the eurozone has already given it further debt relief of around 40 billion euros. Subtract that and its borrowings would be under 130 percent of GDP – still high but not out of line with other indebted European countries such as Italy.

Although present value calculations are useful, they are extremely sensitive to the assumed discount rate – a guess at what Greece would pay on its loans in normal conditions. That’s why it is important to look at other yardsticks.

Gross financing needs

The one increasingly favored by both the IMF and the eurozone is gross financing needs. This measures how much a country needs to find each year to pay interest and repay debt as a percentage of its GDP. It looks at a government’s debt burden from a cash flow perspective.

The IMF says a country like Greece shouldn’t have financing needs above 15 percent but, in fact, its needs are projected at more than that.

Again, this is useful but not enough on its own. One problem is that the IMF hasn’t published any research that validates the 15 percent figure. It merely states this is the magic number for emerging markets, while advanced economies can get away with 20 percent.

The IMF is implicitly treating Greece as an emerging market. Although this is reasonable in the midst of the current crisis, it may not be the right way of looking at the country in the future. After all, if the bailout works, Greece will eventually become a reasonably advanced economy and may then be able to support higher financing needs a decade or so from now.

Another problem is that, if the IMF’s numbers are correct, other countries may need debt relief. Portugal’s financing needs will be 20.1 percent of GDP this year, according to the IMF.

Gross financing needs also lump interest and debt repayments together. This is too crude. After all, a country that just needs to refinance its debt will find it easier to raise funds in the market than one that needs to borrow to pay interest.

Holistic view

This is why it is also important to look at a government’s interest payments as a percentage of GDP. On this yardstick, Greece doesn’t look too bad because its debt has low rates. It has to find 4 percent of GDP to service its borrowings, less than the 5 percent that Italy and Portugal have to pay, according to the London School of Economics’ Paul De Grauwe.

When looking at the health of a company, it is wise to examine its balance sheet, cash flow and profit. Similarly, with a government, one should look at its debt, gross financing needs and interest payments.

Taking such a holistic approach, Greece needs some debt relief. But the eurozone can probably achieve this by stretching out still further the amount of time Athens has to repay its loans. It may not be necessary therefore to cut their face value.

[Reuters]