Another debt restructuring needed

The likely agreement between Greece and the troika on the terms of the new economic program and the level of private sector involvement (PSI) will significantly raise the cost of a Greek exit from the euro. However, it is likely not to be enough for Greece to avoid another major public debt restructuring down the road.

When this article was being written it was not clear whether Prime Minister Lucas Papademos and the three political leaders would reach an agreement with the representatives of the European Commission, the International Monetary Fund and the European Central Bank — collectively known as the troika — on the second economic program.

We have always assumed, however, that the stakes are too high for both sides to fail to reach a fair compromise, and therefore we will proceed on the assumption that there will be an agreement on the terms of the second bailout package and the PSI plan will be implemented.

In this light, we argue that the agreement acts as a barrier against a potential Greek exit from the eurozone because it shifts to a large extent the cost from the private sector to eurozone countries. Therefore, it should put to rest for quite some time talk of Greece?s euro exit in official circles, which was not the case before former Premier George Papandreou came up with the idea of a referendum on the agreement reached at the European Union summit last October.

It is noted that Greek government bonds in private hands accounted for more than 90 percent of total public debt in 2009. At the end of 2011, the percentage is estimated to have fallen to about 56-57 percent as official loans by eurozone countries and the IMF replaced expiring bonds and the ECB amassed some 40 to 60 billion euros of Greek bonds.

Assuming the PSI plan is implemented and participation in it is very high (exceeding 92 percent), the share of Greek bonds in the country?s total public debt is estimated to fall further to below 24 percent. Greek entities such as banks, pension funds and others will end up holding between 6 and 8 percent, with non-residents accounting for less than 16 percent. In other words, the official sector will become the biggest holder of Greek debt.

Readers are reminded that the second bailout package calls for 130 billion euros — which may be revised higher — in new loans, of which 89 billion euros should be disbursed in the first quarter of this year. This is in addition to the first financial package equal to 110 billion euros from the EU and the IMF, of which more than 72 billion euros has been disbursed so far.

The cost of letting Greece go down is even bigger if one takes into account the eurozone?s exposure to the country via the ECB?s liquidity operations and emergency assistance, put at more than 100 billion euros.

Moreover, the ECB and eurozone national central banks, which comprise the Eurosystem, are exposed to Greece in another way. This is the case because many eurozone countries have not adopted legislation on sovereign immunity, including protection from pre-judgment attachment of foreign central bank assets, unlike in the US and the UK.

So, central bank assets would not be fully protected and instead would be exposed to litigation risk if Greece were allowed to default. This is an argument in favor of the ECB?s contribution to the reduction of the Greek public debt and a reminder of the legal issues which would arise should Greece and its official creditors not reach an agreement.

Even though the costs of a euro-area exit for Greece will rise significantly following an agreement and subsequently a high participation rate in the PSI, the chances of the country needing another major public debt restructuring down the road are real.

By all accounts, the troika is aiming at a Greek public debt to GDP ratio of 120 percent by 2020 to make it sustainable. The IMF appears to have called for additional debt reduction or/and official loans to attain this objective after revising its assumptions to take into account the worsening macroeconomic conditions and more realistic proceeds from privatizations.

Although the new calculations appear to be more pragmatic, we think there is a real risk of Greece falling deeper into the debt trap, despite the expected significant debt relief of some 100 billion euros from the PSI. This is so because the Greek economy appears to have entered a new low-growth phase which the new economic program may protract further by including more austerity measures in the form of higher taxes and few initiatives to boost economic growth.

According to Deputy Finance Minister Professor Yiannis Mourmouras, a member of the conservative New Democracy party, the country implemented austerity measures worth more than 43 billion euros in 2010-11 to have the budget deficit shrink by some 16 billion euros. In reality, the deficit reduction was smaller by some 1-2 billion euros due to one-off expenditures recorded in the budget of 2009, an election year.

All in all, the expected new agreement acts as a barrier against a Greek exit from the euro area but may not be enough to exclude another major restructuring of the Greek public debt down the road.

This time, though, it will involve the holders of Greek debt, namely the country?s official creditors and is likely to take the form of 30-year loan extensions a la Paris Club and Iceland.