Conditionality is vital, not PSI+

If local politicians and the press were right, an agreement on the bond exchange — widely known as PSI+ — is perhaps the most important step in Greece?s quest to receive the second bailout package of 130 billion euros from the country?s international creditors. However, although the private sector involvement plan is significant, it is not as crucial as an agreement between the government and the troika on conditionality, namely the conditions attached to the new loan and their use.

Less than a week or so before the chief inspectors of the troika — representatives of the European Commission, the International Monetary Fund and the European Central Bank — arrive in Athens for what could be a make-or-break mission for Greece, many in the country seem to be focusing more on the financing component of the economic adjustment program rather than the most important, namely conditionality.

There is no question that the reduction of the country?s public debt by some 100 billion euros envisaged in PSI+ is important for the debt to become sustainable. Readers are reminded that Greece is asking its private bondholders to voluntarily accept a 50 percent haircut to the 206-billion-euro debt and receive some cash and new, 20-30-year bonds.

If one believes local bankers and government officials, there is reason to hope negotiations or, better, talks — there is a significant difference in using the word ?talks? instead of ?negotiations? according to legal advisers if the bond exchange is to be deemed voluntary — will conclude soon.

However, an agreement on the terms of voluntary PSI+ between Greece and the banks does not guarantee its success. First, the 2012 Greek budget calls for a very high participation rate, around 92 percent or higher, to reap interest savings of 3.5 billion euros or more but this is highly doubtful if the bond swap is to remain voluntary.

Greece could impose the terms of the PSI agreement on the holdouts to achieve a 100 percent participation rate, but that would almost certainly be deemed a credit event, triggering credit default swaps on Greek bonds. It is noted that a buyer of CDS can either offset his loss on his bond portfolio when the contracts are triggered or make a profit if he holds no bonds, that is, bought them for speculation.

Second and most important for PSI, even if one assumes the kind of participation rate sought by the government, the bond exchange may not take place if the temporary European Financial Stability Facility does not provide private bondholders with 30 billion euros in cash or collateral for the principal of the new long-term bonds.

Moreover, it is known that PSI+ will create a sizable capital shortfall for Greek banks which will likely be augmented by the results of the diagnostic tests on their loan portfolios conducted by BlackRock Solutions. That?s why some 30 billion euros has been earmarked for their recapitalization from the second bailout package.

This is not to mention the guarantees the EFSF will have to provide the ECB for the period Greece will be rated in selective default by at least two major credit rating agencies, namely S