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Mr. Regling's "Alternative Facts" About the Greek Debt

posted by Mark Weidemaier

(This is a joint post by Mark Weidemaier and Mitu Gulati.)

In November 2016, Klaus Regling, managing director of the European Stability Mechanism, announced that reforms were going so well in Greece that it would be able to return to the private debt markets by 2017. It's 2017, and neither the markets nor the IMF seem to share the sentiment. Yields on Greek bonds, already high, have increased, and the IMF has concluded the debt is unsustainable. Greece needs an infusion of cash to make a large payment due in July, but the private debt markets aren't willing to oblige.

What does Mr. Regling say? That the IMF (and, apparently, the markets) are wrong; that the ESM's long time horizon and Greece's relatively low debt servicing costs mean there is no cause for alarm (Financial Times, subscription required). Referring to the 174bn euros that the ESM and EFSF have already lent to Greece, he says: "We would not have lent this amount if we did not think we would get our money back." Implication: the IMF and the Euro area nations should lend even more.

What is really going on? As is made clear in this recent Financial Times column by Wolfgang Münchau, and this Bloomberg column by Ashoka Mody, no one seriously believes Greece will repay its debt in full--at least, not within the lifetime of anyone alive today. The real dispute is not about sustainability; it is about the timing of debt relief. For the most part, any new money will be recycled back into the pockets of official creditors. But while official actors keep busy shuffling money from one pocket to another, this mountain of debt will continue to darken Greece's economic prospects.

For political actors in some Euro area countries, there is a compelling political case for deferring questions of debt relief. Elections loom (in the Netherlands, France, Germany, and perhaps Greece), and politicians in northern Europe are reluctant to acknowledge the fiscal transfers that have taken place over the past seven years. Greek politicians are likewise unwilling to admit that they have presided over the creation of an ineradicable debt burden that will blight economic prospects for the foreseeable future.

One solution, favored by some northern European politicians, is to boot Greece out of the Euro area, perhaps accompanied by debt relief. Legally, this may be a plausible option. The question is whether there is a politically and legally realistic alternative given the current political reality, in which politicians in northern Europe need to tell voters that every penny lent will be repaid.

One option is to maintain the status quo, perpetuating the illusion that Greece's debt is sustainable. This appears to be the course favored by Mr. Regling. But as we said a few weeks ago in discussing Paul Blustein's Laid Low, that movie never ends well. Rather than perpetuating Greece's mammoth debt overhang, Euro area leaders need to create incentives for private sector lending to Greece. This will require modifications to the current loan arrangements, but these need not reduce the amount of the Greek debt. (To be clear, we think the amount should be reduced; we are simply acknowledging what appears to be the current political reality.) Instead, the modifications must make clear that new private sector loans will be functionally and legally senior to the existing pile of official debt. Two years ago, this would have been a relatively simple task. Perhaps there is still time. In that event, Mr. Regling's alternative facts might become, well, facts.  


Adjusting the seniority of the debt is an interesting approach. One mechanism to do it may be to model a retroactive change in contract terms similar to what Greece did, but rather than insert CACs official creditors would agree to subordinate their debt to the new private sector creditors. Official creditors may have an incentive to do this, because they likely never expected to be fully repaid, and this has the added benefit of not requiring more official sector bailouts. It has the aded benefit of not presenting a moral hazard issue which Germany has been routinely adamant about. One critique may be that such an approach would run into a "no more Argentina" situation Blustein discussed.I guess the crux of the issue is whether a change in seniority adequately "bails in" private creditors.

Following on from the comment above, I think it is too little too late. If I was a private investor, I have a plethora of other bonds to buy, so why would I risk dipping into the craziness that is Greece?

The ESM is not willing to admit reality and as explained by Laid Low this is all because they are trying to protect Europe as a whole and the Euro. This is ridiculous. Greece is suffering and there is no sign of light at the end of the tunnel. (See https://www.ft.com/content/44478b7e-dd09-11e6-9d7c-be108f1c1dce) If Greece has any chance of survival, they need to leave the Euro. It is going to be awful there for a while, but there is no chance of real recovery if ESM does not face reality and stops being so blindsided by its concerns of spillover. They need to stop putting Europe on a pedestal and face reality, and Grexit may be the only option because who knows if extensive debt relief is ever going to happen if all Europe can see are these "alternative facts."

Additionally, there is a nationalist epidemic emerging throughout the West and if if it spreads to the rest of Europe (i.e. LePen being elected in France), the euro is done, therefore, if Greece leaves now they are just getting ahead of the curve.

If official creditors are unwilling to change the seniority of their loans without testing the waters, Greece could try instead to issue asset-based bonds in the upcoming months to assess private creditor's willingness to lend without further debt relief from official creditors. This option would only change the official creditor's "seniority" in relation to the assets used to back the new bonds, being a good stepping stone for a bigger change. Nonetheless, the European creditors would still need to consent to the issuance of secured bonds, and waive their pari passu and pro rata claim to the securities, which is included in the ESM and EFSF loans. Also, Greece may be hard pressed to find sufficient assets to back a sizable issuance. Since many of Greek's enterprises are yet to be successfully privatized, it might be worthwhile to explore whether they could be used as collateral in this issuance.

Greece should leave the Euro because it is a failed experiment. At this point, booting Greece from the Euro has the potential to make matters worse. In addition to the debt crisis a currency crisis would be introduced.

The alternative solution of incentivizing private sector lenders seems unlikely. Who wants to lend to Greece? Even with attractive contract terms that promise lenders seniority, how many times have the most ironclad contracts been subject to less than ideal interpretations when a dispute arises? Regardless of how clear the contract terms are between Greece and the potential private sector lenders, it is foreseeable that in a moment of crisis those terms could be rendedered less attractive.

The time has come again when we have to contemplate a potential Grexit.

Would a Grexit be better for Greece or the EU? Non-evident and non-obvious. Grexit will mean devaluation of drachma by at least 50%. Since most of Greek debt is now English law governed (payable in euro), the debt burden increases. Even with further debt relief, the ultimate debt burden might not be reduced in absolute terms. The Grexit idea is that with a devalued drachma, exports will boom and the economy will pick up. But Greece primarily exports agricultural products, whose prices are governed and fixed by EU competition policy. So as long as Greece is in the EU (even if out of EMU), the above rationale might fail. Import prices will exponentially increase as well, with obvious catastrophic consequences for a large part of the population. If Greece leaves the EU, it will be the beginning of the end for the EU as a whole, especially with the current economics of Italy and the politics of France and other countries with nationalistic/populist uprisings. The only way a Grexit will work economically is with robust structural economic reforms that necessitate the booting of SYRIZA and a lot of time. The time is not ripe for a Grexit, neither for Greece nor for Europe.

Has Greece ever complied with its commitment on economic reforms? Given the economic disparity with other EU countries, substantial adjustments to wage level seem to be inevitable if Greece wants to stay in the EU. While the economic reform would be painful to Greece people, the people of other EU countries may regard the pain as the reasonable consequence of their past profligacy. Without performing the commitments they made, how would the request for debt relief be justifiable? Since the official creditors in EU area allowed Greece to pay its debt using the money they extended and the previous bondholders succeeded in exiting from the situation, the cost of sticking to the current program would finally be incurred by them. While the existence of the bonds issued on 2014 makes the situation more complicated, it seems that those official creditors have a legitimate reason to require Greece to stay with its commitments.

All this debating about Greek debt obligations to the Eurozone is really senseless because...Greece really does not face any debt burden with respect to the Eurozone (not in the coming years anyway).
Partial redemptions of principal amounts on EZ loans do not start until 2020-22 and final maturities go all the way to 2040-2060. Interest rates are 0-1% and in any case not payable on most of the debt until 2022. And we all know that those maturities and interest holidays could be extended further and further and further.
Greece´s effective debt-to-gdp ratio is not 170% because the EZ loans (230 billion as of today) won´t be repaid in decades if at all and the interest rate is effectively 0%. So the real effective ratio is more like 40% debt-to-gdp. Pretty affordable.
Only real issue are IMF loans and bonds in ECB-private sector hands. 60-70 billion in total?

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