Mandatory haircut to Greek debt seems inevitable
The financial markets have demanded a clear-cut solution to the Greek public debt crisis for a long time, but the Greek and the other eurozone governments seem to have chosen to shrug it off or at least pay little attention to it. It is time they change tune and confront the crisis head on, admitting that Greece cannot repay its huge public debt fully and on time.
After the Greek government announced the new set of austerity measures, we said it may have been able to convince its EU partners and the IMF to provide it with the next bailout tranche of 8 billion euros, but questioned whether it would be able to have the same success with the markets. Well, it is clear by now that the markets were not convinced, though the usual EU cacophony over the future of the country should also be blamed for this.
Signs of economic weakness on the continent and in the United States, the Fed?s unusual struggle to reassure markets and the markets? focus on European banks in recent weeks, highlighting the feedback loop between credit institutions and sovereign issuers, have not helped either.
In late July, after the EU summit we wrote that its decisions were more important for the rest of the eurozone than for Greece because of the increased powers and flexibility given to the European Financial Stability Facility (EFSF) mechanism to stem contagion more aggressively.
Although the summit?s decisions improved Greek debt sustainability through lower interest rates and an increased focus on structural reforms, it did not do much to cut its debt-to-GDP to reasonable levels.
Debt buybacks and private sector participation (PSI) would have slashed the country?s public debt by some 12 percentage points at a time when the IMF?s latest forecast puts Greece?s debt-to-GDP ratio well above 180 percent in 2012.
It would have taken a determined government working full time, an efficient Greek state apparatus and a fast decision-making process at a pan-European level to implement the decisions and start delivering results to convince the markets this time was different — this, once again, was not the case.
Judging from recent developments, it is clear that things have not gone the way they should have or were hoped for. Of course, it is easy to get carried away with the negative psychology of the markets, though we do not think this is the case.
Although the Greek government will try to implement the new austerity measures it is not at all clear whether it has the time it needs to convince the markets and its partners that this time things will be different.
In this respect, it is better to consult Greece?s partners and to try convince them that the best solution is indeed the one Greek Finance Minister Evangelos Venizelos referred to when he spoke to his party?s lawmakers last week. That is, relieving Greece of part of its public debt while staying in the eurozone, or a soft default scenario.
This, we think, is the clear solution to the Greek debt crisis that the markets have demanded for quite some time and will most likely enforce it if EU leaders continue to drag their feet. Of course, the EU could take the easy route via an extended Greek debt buyback program, though this is unlikely because of political resistance in key eurozone countries. The EFSF could provide either funds or its bonds to Greece to swap them at low market prices with existing Greek bonds and cut its debt this way.
Otherwise, the authorities will have to think along the lines of a mandatory haircut on all Greek bondholders to bring the debt ratio closer to 100 percent of GDP. This should range between 40 and 80 percent depending on the debt instruments included. Of course, this will have undesirable consequences because it would activate CDS on Greek debt and prop up the CDS of other eurozone countries.
Moreover, Greek and some other European banks will have to be recapitalized in this event via the EFSF and Greece will still have to carry out reforms and still give up some sovereignty. But, it will be able to convince the international investment community that its debt ratio is at a sustainable level and to attract foreign direct investment flows to counteract the effects of fiscal austerity.
As we have pointed out, there is no easy solution to the Greek debt problem, but if there is one it has to be clear-cut and straightforward to approach the endgame and please the markets. In this regard, Greece and the eurozone should prepare for dealing with the consequences of this solution rather than beating around the bush as they have been doing for quite some time. In other words, Venizelos was right.
