Government, European Union and International Monetary Fund officials continue to reject the prospect of Greek debt restructuring but the markets apparently think otherwise.
Still, the scenario of a soft restructuring or reprofiling of debt, as some call it, has been gaining support among local politicians and others, although it is not clear whether this is the best of all possible worlds to recall. Perhaps nothing can demonstrate it more clearly than its impact on Greek banks.
While government and most EU politicians stick to their anti-restructuring rhetoric, bond markets have sent their message by taking the risk of Greek sovereign default to new highs and the prices of bonds to new lows.
Apparently, the markets pay more attention to the facts than most politicians. The undisputed fact is that Greece will either get fresh funding from the European Financial Stability Facility (EFSF) in the first quarter of 2012 to the tune of 25-30 billion euros for that year or it will have to reduce its borrowing requirements by restructuring its debt.
From the point of view of the governments of core eurozone countries such as Germany and other AAA-rated countries like Austria and Finland, providing more loans to Greece amounts to an almost impossible political task. So, restructuring should be more welcome than fresh lending.
But it would be better for any form of debt restructuring to be pushed back. Credibility is one of them as high-level EU officials and others have repeatedly rejected it, ECB officials have adamantly opposed it and no sovereign default assumption is incorporated in the EU bank stress tests. Obviously, it would not have helped the EU?s credibility if it consented to a Greek debt restructuring in the near future.
Moreover, it would not have helped the ongoing negotiations between the EU-ECB-IMF officials and the Portuguese on the austerity program. Postponing the restructuring for later is also preferable from the point of view of Greek and other EU banks which hold local bonds since they get full payment for maturing bonds from the 110-billion-euro bailout.
From Greece?s point of view, delaying the debt restructuring, if it cannot be avoided after all, may not be the best choice although it may help local banks somewhat due to maturing bonds. This is so because the vast majority of Greek bond debt has been governed by Greek law. This means the country can change the law to facilitate the type of restructuring it deems proper.
As time goes by, more and more Greek debt is transferred to official creditors such as the EU, IMF and the ECB from private bondholders, limiting the impact of any legislative measure on the debt stock. Some 100 billion euros of Greek debt is mainly in the hands of the eurozone countries and the ECB. The general government public debt stood at 340 billion euro at the end of 2010.
At this point, a soft form of debt restructuring that involves a maturity extension of a good part of Greek debt held in private hands on a voluntary basis looks more likely than any other before the end February 2012. This may or may not be accompanied by a reduction in the coupon rate of new bonds to be exchanged for old bonds with the same face value.
The average coupon rate of outstanding Greek bonds is estimated at around 4.8 percent so a cut to 3.5 percent would produce considerable interest savings. But this would convince on the one hand fewer private creditors to accept the Greek offer and on the other hand trigger the credit default swaps that would create problems for some institutions and reward speculators betting against Greek solvency.
Some local bankers argue that a mere voluntary extension of Greek bonds held by banks at a historic acquisition price rather than the much lower current price in the so-called ?held to maturity? bond portfolio would not affect their capital adequacy Tier I ratio under International Accounting Standards.
However, some analysts abroad do not share this view, arguing the opposite.
Even if the Greek bankers are right, there is no question that local credit institutions may be affected in another way if they participate in a maturity extension plan. Their bonds placed with the ECB for collateral will be worth less than before and therefore they will be eligible for less funding unless they post more collateral which is extremely difficult to find under the current circumstances.
Remember that local banks have borrowed some 98 billion euros from the ECB by posting collateral of 140 billion euros in bonds, state-guarantee bonds and other instruments. The ECB reportedly has told them to draw up plans to reduce their exposure.
So some Greek banks may have liquidity problems if they participate in such a plan and it is well understood that banks fail because of liquidity not capital.
We argued last week that Greece will have to play hardball if it comes down to negotiations about a potential debt restructuring. This is more so since the ESM mechanism, which succeeds the EFSF after mid-2013, is partly to blame for the country?s inability to access the markets due to the likely precondition of debt restructuring for a country entering the ESM.
If the country finally decides to go ahead with a voluntary maturity extension of its debt, it should insist on a Brady bond plan with the EFSF or other EU-IMF facilities providing funds or other means to collateralize the new par bonds with longer maturities. This way creditors will be able to swap their old bonds for new long maturity bonds with or without a lower coupon and local banks will be able to fund themselves in the repo market more easily and in turn fund the Greek economy to help service the public debt.
Any other maturity extension plan or reprofiling of the Greek debt without a Brady bond feature may prove inadequate in the medium term.