Haircut?s pros and cons for Greece

By Dimitris Kontogiannis

By all accounts, the EU appears ready to depart from its current approach to the eurozone sovereign crisis centered on dealing with liquidity problems now and solvency issues later. The new approach appears to be more holistic as it tries to address the Greek public debt overhang and the contagion to other countries. Greece should prepare for the consequences.

Countries and policymakers should not repeat the same mistakes and put politics before economics. This is more so if they are large countries like Germany.

After the fall of the Berlin Wall, West Germany decided to reunify with weaker East Germany at a one-to-one exchange rate because it judged good politics should prevail over bad economics. It took almost a decade to absorb the costs of that approach.

Germany, the largest economy of the eurozone and biggest contributor to EU bailouts, felt it was politically correct to support a liquidity approach for Greece?s and perhaps other EU peripheral countries? solvency problems in 2010, although it perhaps understood this solution was not the best from the economic point of view.

The Greek economic adjustment program agreed with the troika back in May 2010 was a manifestation of the liquidity approach. As some critics expected, the approach simply delayed the day of reckoning.

On one hand, it failed both to facilitate Greece?s return to the international capital markets in 2011 or early 2012 as initially projected and to restore economic growth, and, on the other, it exposed the core eurozone countries to contamination.

In other words, this approach may have been good politics but it was certainly bad economics.

Germany appears to have learned the lesson by reportedly insisting on providing a greater debt relief to Greece than envisaged in the decisions of the EU summit on July 21.

Given its weight in EU decision-making, one should expect it to prevail after yielding some concessions to France and others.

Of course, this set of decisions, which normally will give bigger firepower to the European Financial Stability Facility (EFSF) and call for the recapitalization of European banks to be able to withstand large losses from periphery bonds, will entail a reduction in Greece?s debt burden.

It looks quite likely that private holders of Greek bonds will have to suffer steep losses if a NPV loss or haircut of 50 percent or greater is imposed voluntarily or not as expected. Unfortunately, Greek banks and social security funds will have to pay the price of their own past mistakes in holding too many local bonds and trusting Greek politicians. So, bank shareholders will most likely lose a great deal of their property and pensioners may risk losing part of their future income.

Of course, there may be more negative side effects in the Greek economy. Greek borrowers may seek similar treatment from local banks, namely a haircut on their loans, which could increase non-performing loans (NPL) in the local banking system even further.

Even now, some sophisticated borrowers have tried to take advantage of Greek banks? need to deleverage and boost their liquidity by offering them mutually advantageous deals, amounting to a haircut.

One may also expect that the haircut mentality will pass on to companies, which may demand a haircut in their deals with their suppliers and others, boosting the numbers of bankruptcies. Even consumers may start asking for lower prices after the haircut.

However, one should remember that everything, more so a haircut on a state?s obligations to creditors, has implications. The most important thing is whether the government, the banking sector, the business community and the trade unions are ready to handle the consequences, as doing nothing will be worse.

Those in Greece who oppose a sizable reduction in the Greek public debt because of its adverse side effects should remember that the continuation of the current situation will breed more uncertainty, and hurt market sentiment and the real economy even further.

The market has been saying all along to all parties involved in the Greek and eurozone sovereign crisis that a final comprehensive solution has to be found. Germany, more than anybody else in the eurozone, appears to have got the message and be ready to act.

The Greeks should not oppose a sizable cut in the country?s public debt because of its negative effects. After all it was they, particularly the government, the political elite and the labor unions, who opted for this solution by objecting to a sizable haircut in the public sector, the country?s main source of economic problems.