Tweaking recap coverage will cut debt

The IMF’s assessment of the first Greek bailout program is correct overall and the self-criticism it has exercised should be welcome. In a number of aspects, it agrees with part of the criticism directed at the design of the original plan over the past few years. But the main goal of the assessment appears to be to highlight the importance of making the Greek public debt sustainable as soon as possible. The ball is obviously in the eurozone’s court but there are no signs it is willing to score.

Dominique Strauss-Kahn, the former managing director of the International Monetary Fund (IMF), was right when he reportedly told Greek officials back in May 2010 that the country’s best course of action would be to restructure its public debt, essentially to default. Nevertheless, the then socialist government under Prime Minister George Papandreou had neither the guts nor a plan to follow his advice in the face of strong objections from Germany and France.

The two core countries of the eurozone knew that some of their banks would have ended up with a big capital gap because of the large holdings of Greek government bonds (GGBs) and they also feared creating havoc in international financial markets if they agreed to a Greek debt restructuring at the time.

It is reminded that Greece signed the first Memorandum of Understanding (MoU) with the European Commission, the IMF and the European Central Bank in May 2010, having been shut out of the markets after the relevant Greek authorities had mishandled the seven-year bond issue a month earlier.

There is no doubt that the first adjustment program failed in many respects. The economy shrank by 4.9 percent in real terms in 2010, 7.1 percent in 2011 and 6 percent in 2012 compared to the plan’s forecasts for a decline of the real gross domestic product (GDP) by 4 percent in 2010, 2.6 percent in 2011 and real growth of 1.1 percent in 2013 and 2.2 percent in 2012 .

What’s more, the unemployment rate was supposed to peak at 14.8 percent in 2012 from 7.7 percent in 2008, but instead rose close to 27 percent according to the most recent data.

Of course, nobody wants to father a failed program, especially if they have financed it. Therefore, it comes as no surprise that German and other European Union officials blame the failure of the program on the insufficient implementation of structural reforms by the Greeks. On the other side, critics of the program largely blame excessive austerity, which helped increase resistance to reforms as well.

Although the insufficient implementation of reforms has played some part in the program’s failure, it is the overdose of austerity in a largely closed economy along with a developing credit crunch that caused the most damage in this country.

First-quarter figures for 2013 showing single digit growth in Greek merchandise exports despite a sharp decrease in unit labor costs – a yardstick for international competitiveness – in the last couple of years appear to vindicate the second school of thought. This is because structural reforms usually yield fruit in the medium-to-long term, after inflicting costs and pain in the short term.

Undoubtedly, the IMF’s emphasis on rendering the Greek debt sustainable is justified since this will open the way for the state to return to borrowing in international markets at reasonable interest rates, boost economic sentiment, prop up investment spending and lay the foundations for growth. However, this is a call that will be made by those who pay, namely the eurozone and especially Germany. It is definitely not an easy decision.

German government officials appear to be opposed to a haircut on the principal of the Greek Loan Facility (GLF), amounting to more than 52 billion euros, but one has to wait for the outcome of the German elections in the fall before drawing any conclusions.

Eurozone leaders could help avert a haircut and still cut sovereign debt sufficiently by allowing or at least leaving the door open for the European Stability Mechanism (ESM) to recapitalize banks retroactively in the next summit in June. In this case, Greece could see its debt get slashed by up to 30-35 billion euros, or more than 15 percentage points of GDP in the future.

This way, eurozone member states could make good on the decision that they adopted last November to take steps in 2014 and 2015 to bring the Greek debt to a level substantially below 110 percent of GDP by 2022. It is generally assumed that further interest cuts in the GLF and European Financial Stability Facility (EFSF) loans could drive the debt ratio down to 124 percent in 2020, but many think it would take principal haircuts on the GLF to go well below 110 percent by 2022.

Allowing the recapitalization of eurozone banks by the ESM retroactively makes that possible, without resorting to principal loan haircuts or playing around with structural funds earmarked for Greece.

If the IMF’s intention was to refocus the debate on the sustainability of the Greek debt by referring to the shortcomings of the first Greek adjustment program, it has certainly been successful despite irritating the EU and the Germans in particular. Whether it can lead to a solution where common sense rules over the creditors’ belief that debtors must suffer for their sins is something that remains to be seen.