'Debt socialisation' might follow Greek crisis

Europe can breathe a little more easily after the Greek Parliament’s vote in favour of the austerity bill yesterday. Talks on a voluntary rollover of Greek public debt by private lenders are ongoing. But can we sit back and have more confidence that the euro-area sovereign debt crisis will be resolved? Unfortunately not.

The Greek vote was necessary to avoid an immediate crash and it was a wise decision. It complements the Greek government’s heroic efforts to keep control of public finances and introduce growth-enhancing structural reforms. With or without public-debt restructuring, further austerity is needed: before the vote, the 2011 budget deficit was 10.5 percent of GDP, of which about two-thirds is used for paying the interest on debt. Clearly, even in the event of a default and the unlikely case of complete denial of interest service, there still would be a sizeable budget gap to be closed.

The vote opens the way for continued discussions about a voluntary rollover by Greece's private creditors. Little is known about this as no official document is available, but a leaked version of the alleged proposal has seen the light. It is complicated, but in essence foresees the reinvesting of 70 percent of maturing Greek bonds into new 30-year maturity Greek bonds at an annual interest rate of 5.5 percent, with an increase to 8.0 percent if Greek GDP growth turns out to be spectacular.

This is a useful initiative. If pursued, it can give more time to Greece and the eurozone. This is of particular importance in the face of predictions of financial armageddon in the event of a Greek default. Also, voluntary private sector involvement could calm somewhat citizens’ anger in core euro-area countries against the second official programme of lending to Greece, which is to be approved in the coming weeks.

However, if further austerity and voluntary rollover on the part of private creditors will be sufficient to bring back Greece to solvency is another question. First of all, implementation of the new Greek austerity and reform programme might prove difficult given the widespread social unrest and the resistance of various interest groups. Also, for the voluntary private rollover of debt to be effective, the participation of a critical mass of current bondholders would be needed, and there are good reasons to be sceptical about its success.

But even if the new programme and the voluntary rollover were successful, it is unlikely that they would solve the problem once and for all. The just-passed €28 billion fiscal adjustment, to be implemented during the next few years, will reduce somewhat Greek public debt, which otherwise could reach about € 400 billion by 2014. It is hoped that the voluntary private sector rollover can amount to €50 billion, which will ease the short-term funding pressure. But these moves will not change the basic parameter of the equation: Greek public debt will still remain at about 150-160 percent of GDP, which is simply too high.

With such a high level of debt it is unlikely that market access will be restored by 2014, the likely end date of the second lending programme and the period during which voluntary rollover is promised. Without market access, the euro area will face hard choices again. One is a third official lending programme with perhaps a new effort to involve private lenders. The other is debt restructuring with a sizeable debt reduction. But by 2014 it will be clear to everyone that continued official lending is viable only at a very low official lending rate. Also, continued official lending will lead to the official takeover of Greek debt, which is sometimes called ‘debt socialisation’. Debt socialisation would require extensive changes to the functioning and the institutional framework of the EU. An honest discussion of these changes should start soon, if debt restructuring is to be avoided at any cost.

But even if euro-area partners will stand ready to lend to Greece at a very low interest rate for decades to come, a sudden collision may occur. Greek opposition parties and protesters in Syntagma square are unhappy, and an eventual new government may decide to reverse the austerity measures. Due to domestic political changes, a bilateral lender may unilaterally decide to stop disbursing further loans to Greece, putting official lending at jeopardy. The collision may lead to a haircut for official lending which in turn could culminate in a euro-area wide political crisis with wide-ranging consequences.

Therefore, the risks of continued official lending without a significant debt reduction are numerous. But debt restructuring has the potential for creating significant adverse effects within Greece and beyond its borders. The valuable breathing space gained yesterday should be used wisely to prepare for an eventual collision, and at the same time to assess and prepare for the implications of debt socialisation. But is debt socialisation the way we really want to follow?