Second package seems insufficient

As time goes by it becomes increasingly evident that the deal struck at the eurozone summit on July 21 may not be the turning point the European leaders had hoped for and talked about.

By deciding to test Italy and therefore the project of the euro, the markets have signaled two things. First, they doubt whether the deal can stop contagion and, second, they doubt whether it resolves the Greek debt sustainability issue. In this regard, Greece and its creditors will have to take another look at the sustainability issue down the road, leading to a second round of haircuts on local bonds.

We had argued after the last summit that the most important decisions centered on stopping the contagion of Italy and Spain by enhancing the role and powers of the European Financial Stability Facility (EFSF) and secondarily about giving Greece more time to put its house in order.

Unfortunately, like many others, we had overestimated the ability of the eurozone countries and institutions to implement these changes as soon as possible. The agreement on the legal document outlining the new role of the EFSF and its ratification by national parliaments looked like it would take longer than initially thought. This, coupled with doubts about whether the EFSF was large enough to initiate large-scale buying of Italian and Spanish bonds and the apparent hesitancy of the ECB initially to fill the gap further, convinced the markets to challenge the euro project by testing Italy.

At this point, it is not clear whether the genie has come out of the bottle, in which case even doubling the size of the EFSF and speeding up the process may not be enough to appease the markets. It is true that a timely intervention by a credible authority can help stabilize the bond markets even if it spends relatively small amounts. However, the eurozone may be beyond this point and repeated interventions with sizable purchases may be needed along with credible economic policy measures in Italy and elsewhere.

Of course, the events in Italy and Spain have shifted attention away from Greece for the moment but this may not last long since the rate of private sector involvement (PSI) in the second Greek package is still an open question. Readers are reminded that private investors will have to either swap or roll over their Greek bond holdings into new ones with extended maturities and/or lower nominal values to the tune of 135 billion euros by end-2020. This way Greece will not have to find the resources to refinance these bonds, reducing its rollover risk for this period.

So Greece may be back in the limelight in the next few weeks in a positive or negative way, depending on whether the 135-billion-euro goal is reached.

Regardless of this, the market seems to discount the fact that Greece will have to proceed with another restructuring of its public debt by mid-2013 to make it sustainable. This is the message sent by participants in the bond and credit default swap (CDS) markets. Of course, one may argue that their pricing partly reflects the uncertainty surrounding PSI participation.

This may be true but it looks as if the reasons for the punitive Greek bond yields and CDS spreads run deeper.

Although the decisions reached at the recent summit clearly improved the sustainability of the Greek public debt due to maturity lengthening and a reduction in interest rates, they did not seem to resolve it.

Of course, one may argue the public debt of any country which is financed by the EU and the IMF and private parties through 2014 is sustainable and this is true provided the country lives up to its promises. So, debt sustainability is indeed a more medium- to long-term issue.

Moreover, one may argue that the optimum public debt ratio is not the same if the country in question belongs to the eurozone, such as Greece, or stands alone. In the first case, the optimum debt-to-GDP ratio may be higher because of so-called externalities than in the second case.

All this may sound trivial but is important in determining whether the Greek debt is sustainable in the long run. It is one thing to have to bring the debt ratio down to 80 percent of GDP because this is the optimum and it is another to have to cut it to 100 percent of GDP in the same time.

Nevertheless, ruling out any beneficial effects on economic growth due to the country?s enhanced credibility on the back of fiscal consolidation and structural reforms, the arithmetic is still challenging.

In other words, Greece will have to cut its public debt even more than the 12 percentage points of GDP or about 26 billion euros via bond buybacks and PSI envisaged in the second rescue package to produce and maintain a feasible primary budget surplus for many, many years to stabilize and afterward reduce its public debt toward 80-100 percent of GDP in the next two decades.

History suggests Greece can sustain primary surpluses in the order of 3 to 4 percent of GDP. It is reminded the primary surplus results when revenues exceed primary spending excluding interest payments on debt.

Assuming an average interest rate of 6 percent on servicing the public debt in the next two decades and relatively subdued GDP growth rates, the resolution of the Greek debt sustainability issue may require another restructuring in the next 12 to 24 months. This way, Greece can bring down its public debt to the 80-100 percent of GDP range by repeating the success of the 1990s where it achieved primary surpluses equal to 3.8 percent of GDP on average.