The apparent success of the private sector involvement, or PSI, for bonds written under Greek law is not a panacea and may have come too late to make the country?s public debt sustainable. Nevertheless, PSI reduces significantly the potential risk of a Greek exit from the euro.
The future government?s ability to capitalize on this lower exit risk to attract private investment and convince the Greek public that the country is making progress will shape Greece?s future to a great extent.
The strong endorsement of the PSI by European Union policymakers and the International Monetary Fund, including the retroactive introduction and use of CACs (collective action clauses) to bonds written under Greek law, amounts to an admission with almost two years? delay that Greece had been facing a solvency problem and not a liquidity crisis right from the beginning.
Since 2010, a number of economists, businessmen and very few politicians have argued that Greece needed debt relief to have a shot at stabilizing its economy while pursuing a policy of fiscal consolidation and structural reforms.
Whether significant debt relief should have come via a frontloaded program of asset sales and privatizations and/or an EU-financed program of debt buybacks and/or public debt restructuring was debatable. Perhaps a combination of the above would have been optimal.
Eurozone leaders did not endorse this strategy in the spring of 2010 for various reasons. They thought it would have sent the wrong signal to other debt-laden periphery countries and would have taken pressure off Greece to stick to the terms of the economic adjustment program. However, the most important reason seems to be their concerns about contagion as a large-scale Greek debt restructuring would have inflicted big losses on major banks and insurers in core countries.
It could be argued the current PSI would have been more effective at arresting adverse Greek debt dynamics by reducing the public debt ratio if it had been implemented earlier — that is, before more than 70 billion euros in Greek bonds turned into EU bilateral and IMF loans and the ECB had bought more than 50 billion euros in local bonds.
Although the haircut — of 53.5 percent applied to 95 percent of outstanding Greek bonds equal to 206 billion euros — implies a debt reduction of more than 100 billion euros, the actual debt relief thanks to PSI will be much smaller initially, driving the debt-to-GDP ratio to between 150 and 161 percent at the end of 2012.
The recapitalization of banks, estimated at 50 billion euros, and the exclusion of intergovernmental bond holdings, such as bonds held by pension funds, from the calculation of the general government debt ratio account for this development, as Nomura analysts have pointed out.
The fact the market was pricing the new Greek government bonds at between 17 and 24 percent of their face value in the so-called gray market last week is not a good omen, although it is still too early to draw firm conclusions.
It shows some participants ascribe a high probability to another Greek debt restructuring down the road. It is noted an investor gets 15 percent in short-term EFSF bonds and 31.5 percent in 20 new Greek government bonds with maturities of 11 to 30 years for every 100 euro cents of old local bonds under this PSI.
Whether the participating creditors are mistaken or not remains to be seen. A cautious stance is justified by the high political risk in Greece, which will remain elevated until the next general elections to be held, most likely, at the end of April or early May.
However, one should also not underestimate the fact that the Greek debt will become largely official after the whole debt exchange is completed under the current PSI. The new Greek bonds will account for about 20 percent of the total general government debt after the exchange, according to some estimates. Moreover, Greece has liabilities to the Eurosystem — the ECB and the system of national central banks — exceeding 100 billion euros.
In other words, the direct and indirect exposure of eurozone governments to Greece will increase substantially upon completion of the PSI and therefore they stand to lose a lot more if the country exits the euro and adopts its own currency. So they have less incentive to let Greece exit, even before the historic implications of the failure of the euro project are taken into account.
Therefore, the current PSI may not do much to cut the Greek debt-to-gross domestic product ratio to sustainable levels initially but it definitely reduces substantially the risk of a Greek exit from the euro. This is something the Greek side will have to drive home to attract private investments from Greeks, the diaspora and foreign investors.
The risk premiums tied to a euro exit which is assigned to Greek direct and portfolio investments is material at this point. So convincing investors there is a significant reduction in the risk of a Greek exit from the euro after the PSI is important in attracting investments and boosting GDP as fiscal consolidation continues to bite. Readers are reminded that the drop in private investment spending has been bigger than the drop in private consumption over the last few years.
It is equally important for the new government to convince the public that the country is making progress on the fiscal and other fronts to help improve consumer and business sentiment and possibly put a halt to the continuous outflow of bank deposits. Speeding up the recapitalization of banks is likely to help to this extent although it cannot do much to reverse the deposit outflows due to the recession.
All in all, the PSI is not a panacea and could have been more effective in making the debt sustainable if it had been implemented much earlier when a good deal of the Greek debt was in private hands. Still, there are strong reasons to argue the current PSI reduces the potential risk of a Greek euro exit. Therefore, the PSI opens a window of opportunity for the new government to capitalize on this and try to attract private investments as it works to prop up public sentiment.