The Greek public debt misery: the right cure should follow the right diagnosis

In sharp contrast to the cautiously positive tone of the 11 October official press release about the fifth review of the Greek programme, the leaked confidential debt sustainability analysis by the troika of the European Commission, European Central Bank and International Monetary Fund (dated 21 October) was devastating, projecting Greek public debt (net of collateral required for private sector involvement) to peak at 186 percent of GDP in 2013 and to stay above 150 percent even in 2020. Market access is unlikely to be restored before 2021. Therefore, without a more sizeable reduction in privately-held debt, official financing would reach € 362 billion by 2020. And this is the baseline. Lower growth, primary budget surplus or privatisation revenues could make debt dynamics even worse.

In essence, the troika's confidential analysis has endorsed the view that there are two ways out of the Greek public debt trap: debt socialisation, ie official lending at a very low interest rate for decades, or a sizeable reduction in privately-held debt (continued official funding is also needed in the second case, but just for a few years and to a much lesser degree). This is a major change compared to the fourth review, which ended on 2 June. The diagnosis has become more honest and hence it’s time to find the correct cure.

Current discussions suggest that there is little, if any, appetite for socialising Greek debt much further, so the real question is when and how to organise the reduction of privately-held debt.

The urgency has increased, because the bank run has accelerated. Deposits in Greece are guaranteed by the Greek government and depositors are right to question this guarantee when the government is on the brink of default. But the bank run could leave the banking sector hamstrung and thereby lead to an even deeper economic crisis. This calls for a prompt and, finally, a credible solution to shore up Greek banks and achieve a sustainable public debt trajectory under reasonable assumptions.

The big question is how. Most policymakers seem to insist that debt reduction should be ‘voluntary’, because three major fears are associated with forced reduction: (1) it would constitute a credit event, thereby triggering credit defaults swaps (CDS), (2) it would set a precedent that other euro-area countries might wish to follow, and (3) it could lead to severe contagion throughout the euro area.

However, we should not fool ourselves that a debt reduction that is labelled ‘voluntary’ would save us from these concerns. As for the first, when the haircut is as high as discussed, ie 50-60 percent, and the agreement results from the threat of default, credit rating agencies and the International Swaps and Derivatives Association (ISDA, which decides about triggering CDS) may be right to conclude that it was not purely voluntary. After all, the net open CDS positions on the Greek sovereign amount to a mere € 3 billion – not an amount that by itself would lead to the collapse of several financial intermediaries. Also, at such a high level of haircut, the risk of free-riding increases, jeopardising the success of the agreement.

As for the second fear, there are objective reasons behind the Greek haircut: public debt is way too high and, without significant debt reduction, there is no hope for market access for at least a decade. Greece has reached this situation after great suffering and after the sovereignty of its government has been curtailed in many ways. Even after default, the country would face numerous difficulties. There is no other country in the euro area with similar objective restructuring needs, and it is not very likely that other countries would wish to follow this bumpy route.

The most serious fear is the third one – but once again, whether a, say, 60 percent debt reduction would be reached ‘voluntarily’ or as the result of coercion is not a big difference: either way, investors in Greek sovereign bonds will have suffered a massive loss.

Therefore, policymakers should not invest too much time in designing ‘voluntary’ schemes. It would certainly be worth a try, such as reverse auction-based debt buy-backs, but there are more pressing issues: (1) finding the proper rate of debt reduction, (2) stopping the bank run and safeguarding Greek banks, and (3) limiting contagion.

The first issue should be delegated to technical level experts, and not to high level policymakers, because the task is closer to being an art than a science and it would be better to carry it out as objectively as possible. The rate of debt reduction should be a once-and-for-all rate and should not be revisited later. The rate should be of course as small as possible, but high enough to ensure that market access will be restored in a few years.

The second issue could be tackled by giving a kind of euro-area guarantee for Greek bank deposits – in the short term the European Financial Stability Facility (EFSF) could be used for this purpose. It might bring about later a unified euro-area wide deposit guarantee system, which is badly needed anyway. Bank runs could also be reduced by a more forceful denial of an eventual Greek exit from the euro-area: an exit would make Greece much worse off than a default inside the euro-area. The capital of most Greek banks would be wiped out by the haircut and therefore these banks will need a lot of new capital that the Greek government cannot provide. Again, in the current urgent situation the EFSF should be used through a new earmarked loan to the Greek government. In effect, this will lead to the nationalisation of banks. Bank losses may go beyond current bank capital, especially if bank balance sheets deteriorate because of private sector losses, as a result of the deeper recession. Therefore, these banks should be restructured and the involvement of junior bondholders may be needed, for which help from the European Banking Authority, or better, a specialised euro area-wide bank resolution mechanism, would be needed. The restructured banks should be sold off later – preferably to major European banking groups. And liquidity should be provided to banks possibly through a special exceptional liquidity assistance facility.

Limiting contagion is perhaps the most difficult task. While, for example, the Italian fiscal situation is sustainable even at current borrowing rates, but it may not be sustainable at a much higher rate. Investors, knowing that such an unfavourable situation could emerge, might shun Italian debt if they see that Greece eventually defaulted despite the uncountable number of promises that it would not during the past two years. The risk of such a contagion will be higher if the upcoming EU summit(s) do not find adequate solutions for strengthening the euro-area’s banking system and making the financial backstop for sovereigns more sizeable and effective. The first lines of defence, of course, should be the adoption and implementation of more credible structural and fiscal reforms in Italy and the design of credible bank stress tests throughout euro area – even if proper execution will take more time than what seems to be available to solve the Greek debt misery. Therefore, the other elements of the package currently under discussion are also crucial. It is indeed time to design a package that is comprehensive not just in name.

Zsolt Darvas is research fellow at the Bruegel think-tank and the author of the report ‘Debt restructuring in the euro area: A necessary but manageable evil?’