By Dimitris Kontogiannis

The political decision to keep Greece in the eurozone for at least another year may have been made, but its creditors are doing their best to undermine it by increasing event risk and further hurting the private sector and the economy in general. In this context, debt relief as a supplement to fiscal austerity becomes more important and the government will have to formulate a strategy on debt reduction despite its limited available means.

German Finance Minister Wolfgang Schaeuble is right to point out that highly indebted countries will have to reduce their debt stock by sticking to fiscal consolidation. But adopting policies aimed at producing large primary budget surpluses to gradually pay off the public debt may be economically, politically and socially infeasible in democratic societies if they result in chronic recessions. That’s why fiscal consolidation is sometimes complemented and facilitated by debt relief.

In summer 2011 eurozone leaders decided to provide some relief to Greece by asking private creditors to take a 21 percent net present value loss on their Greek bond holdings. This relied on the assumption of the country running huge primary budget surpluses, that is, revenues exceeding expenditure without interest expenses, for many, many years.

Soon EU leaders understood this was a futile exercise given the deterioration in the economy and Greece’s failure to honor its commitments under the adjustment program. So, they came up with the second private sector involvement plan, PSI Plus, which included a 53.3 percent haircut on the notional amount of bonds held by private concerns, equal to more than 200 billion euros. The successful wrap-up of the PSI Plus operation resulted in 3-3.5-billion-euro savings in annual interest payments to the budget and the repayment of principal on the newly issued bonds after 2020, lightening up debt redemptions during the adjustment period.

However, the PSI did not provide significant debt relief initially. The debt reduction was based on the idea Greece would be running big primary surpluses around 4.5 percent of GDP from 2014 on to make the debt sustainable, i.e. to fall below 120 percent of GDP in 2020, according to the International Monetary Fund.

David Stockman, the former budget director in the Reagan administration, characterized the debt restructuring “a farce” last May, pointing out more than $100 billion in Greek debt was held by the European Financial Stability Facility (EFSF), the European Central Bank and the IMF, who get paid 100 cents on the euro by issuing more debt to Greece.

Stockman went on to say, “The Greeks are still debt slaves, and will be until they tell Brussels to take a hike.” Of course it’s easy for any outsider who does not fund the country’s needs to say so, but this does not mean Stockman was not right.

The IMF also appears to suggest Greek debt will have to be cut again, this time including the official sector but not the Fund, so the debt ratio falls below the arbitrary 120 percent of GDP in 2020. However, debt sustainability analysis (DSA) exercises are highly sensitive to inputs such as average GDP growth rate, average interest rate paid and primary balance, so their conclusions may turn out to be way off the mark since future forecasts entail a lot of uncertainty.

Greece had a primary surplus averaging about 2.8-3.5 percent of GDP in the runup to the euro in the second part of the 1990s with all cylinders of the economic engine firing. Therefore, an average primary surplus equal to 2.5 percent of GDP is more realistic and attainable in the medium to long term rather than assuming 4.5 percent, as in the second adjustment program. This in turn implies greater debt relief.

Given the newly issued bonds are under English law, which means investors can block any official attempt at restructuring, the burden of any debt relief falls on the shoulders of the official sector, namely the ECB and the EU. The IMF appears to be pressing the EU for such a solution.

In our opinion, the IMF is right on this. But the cost will be borne by the EU so it comes as no surprise that the Europeans are reluctant to make such a commitment. This is much more so since Germany holds elections next fall and bailout fatigue is evident in some northern countries. Still, a politically acceptable solution can be found without including a haircut on the nominal exposure of EU countries and the ECB to Greece.

On its part, the Greek government cannot afford to wait for the disbursement of the next loan tranche. It should continue to buy back bonds, even at small lots, via the Public Debt Management Agency, as it has done in the last month and a half. Moreover, it should try to convince social security funds to switch their EFSF bonds into Greek bonds by providing the necessary legal and other guarantees. Funds got some 3 billion euros in EFSF notes and 7 billion in new government bonds during the PSI bond exchange. The funds held some 22 billion euros in old local bonds prior to the PSI. This means they could buy new bonds worth 6 billion euros or more by liquidating their EFSF holdings. These bonds will be classified as intergovernmental holdings and will not be included in the government debt. On the other hand, there will be no interest savings since interest paid by the central government will be received by other components of the general government.

Reducing the debt ratio by 6 billion euros or some 3 percent of GDP is no big deal. But the purchases send a signal to markets and help prop up the price of bonds in the relatively illiquid market, potentially limiting capital needs for bank recapitalization.

Greece’s creditors have been rightly quick to criticize successive governments for delays and inefficiencies in the implementation of the adjustment programs. But they are also partly responsible for the program being off track because they administered a bigger-than-required and badly mixed austerity dose at the start. In this regard, debt relief is necessary for the success of the program. The Greek side will have to help by mobilizing and using its limited resources smartly.