A Brady type plan may be needed for manageable debt to be growth compatible
Government officials and some market participants believe the country will be able to borrow medium-to-long term funds at affordable interest rates from the markets at some point this year or in early 2012 if it sticks to the economic program and more than halves its debt payments in coming years by lengthening the maturity of its public debt and buying back some of its bonds. On the other hand, others continue to doubt whether this approach will work, citing the high debt-to-GDP ratio and adjustment fatigue. Obviously, both sides cannot be right.
Greek government bond yields have receded from their all-time highs but remain at elevated levels. The 10-year bond yield over Germany has fallen to 830 basis points over corresponding German bonds after rising to 970 basis points earlier this month.
The spread on the five-year CDS (Credit Default Swap), what an investor normally buys to protect against a Greek bond default, has also fallen to around 850 basis points from over 1,100 basis points earlier but is still very high.
All agree that Greece cannot tap international markets for long-term debt at these high rates because this would render its debt dynamics unsustainable. This is because it requires a very high primary budget surplus and high nominal GDP (Gross Domestic Product) growth rates to offset the rising cost of servicing the debt to stabilize the public debt-to-GDP ratio.
The fact that yields have remained elevated although the country has slashed its general government budget deficit by 6.0 percentage points to 9.4-9.6 percent of GDP in 2010 and is fully funded by end-March 2012 from loans provided by eurozone countries and the IMF shows certain things very clearly.
The markets continue to question whether a country with a large public debt and an economy suffering from limited international competitiveness can go through the required internal devaluation in a common currency area to regain competitiveness and service its debt.
Market participants are fully aware that there are a number of examples where European countries, including Greece, underwent successful large fiscal consolidation for many years in the past, but they shared a common characteristic: a usually large devaluation of their national currency, which is not possible for a country participating in the euro area.
Ireland managed to cut its budget deficit by a whopping 20 percent of GDP from 1978 through 1989 but it was helped immensely by large cumulative gains in GDP partly thanks to the devaluation of its currency in the first few years of the adjustment period. Even Greece managed to slash its budget deficit by 12.1 percent between 1989 and 1995 but relied a lot on the devaluation of the drachma to prop up the economy.
In other words, many market participants think countries like Greece face both a solvency and a competitiveness problem but realize that the eurozone has taken measures to deal with it so far as if Greece faced a liquidity problem. It should be noted, however, that this view pays little attention to the medium-to-long term impact of structural measures taken to enhance the competitiveness of the Greek economy.
By all accounts, European leaders appear to be working on a comprehensive plan to provide a lasting solution to the sovereign debt problem. This is likely to include boosting the lending capability of the EFSF (European Financial Stability Fund) to provide both funds to fiscally weak countries and implement bond-buying plans from the ECB and perhaps others. The latter is likely to result in the lengthening of the maturity of the rest of the public debt and lowering the total notional outstanding.
It will also include the extention of the maturity of the 110-billion-euro official loan provided to Greece up to 30 years. All these in exchange for more fiscal commitment from Greece embedded in a constitutional commitment.
Greek officials think that the new plan, along with strict adherence to the deficit reduction targets and the undertaking of more structural measures, will convince capital markets to lend the country medium-term funds later in 2011 or in early 2012 at reasonable rates.
One hopes they are right but it is difficult to see how this can happen without a serious reduction in the debt-to-GDP ratio. Even if the Greek public debt-to-GDP ratio peaked at 150 percent instead of 160 percent, it would have to come down considerably for global investors to be convinced.
Of course, Greece can count on an upward revision of its GDP by 10 percent in 2011 to lower the debt ratio. It can also count on a plan whereas EFSF lends it long-term funds to buy back shorter bonds held by ECB at a discount to par. Assuming ECB holds Greek debt with a face value of 60 billion euro and the country buys it back at a discount, it could cut the debt-to-GDP ratio by 8.0 percent according to Credit Suisse. Overall, the debt ratio will fall to 129 percent of GDP assuming all of the above actions are realized. This will help with the country?s strict adherence to fiscal consolidation and economic reforms and the sharp drop in annual debt service payments in the years ahead as the debt maturity of the Greek debt is extended.
However, the Greek and mostly the European authorities will have to find another way to further cut the debt ratio to more manageable levels if they want markets to deem it sustainable and compatible with modest growth rates in the future. To this extent, a trim via an exchange of existing Greek government bonds with new debt credit enhanced by the EFSF – a Brady type plan – may be the answer. If this is not possible, then the pessimists may be vindicated in the sense Greece may not be able issue medium-to-long term bonds at affordable rates in 2011 and early 2012.
