Interest cut may be key to Greece’s debt

The Greek public debt is projected to rise again this year, with the vast majority of analysts agreeing that it is not sustainable, hurting investment and future economic growth. The Eurogroup has said it will take new measures to bring the debt ratio down to 124 percent of GDP in 2020, assuming Athens honors its commitments. The measures should include the extension of loan maturities well into the future since the impact of lower interest rates is small. In this case, the EU and the IMF may have to revise their definition of debt sustainability and DSA (Debt Sustainability Analysis) since a high debt-to-GDP ratio may no longer be the most important indicator of Greece’s ability to service its debt.

Greece’s gross public debt is projected to rise to around 322 billion euros this year from about 304 billion euros post PSI (Private Sector Involvement) in 2012 and 355 billion in 2011. As a percentage of GDP, it will reach 175 percent this year from 157 percent in 2012 and 170 percent in 2011 according to European Commission estimates. This is huge by any standards and a good reason for domestic and foreign investors to take Greece off their radars.

The markets and many economists could have taken a different view of the debt ratio if the majority of the country’s bonds and loans were owned by domestic investors, but this is not the case. More than 210 billion are in the hands of EU governments, the EFSF and the ECB. The sum becomes bigger if we include the national central banks in the Eurosystem and the European Investment Bank. Italy – a country with a high debt ratio of 120 percent but high domestic ownership of the debt – is an example.

The high debt ratio may not have been such a big deterrent for portfolio and direct investments if the debt had been redenominated in a currency issued by the country because it could have run higher inflation to erode its value. However, this is not the case either – Greece’s public debt is in euros.

So, Greece finds itself in a very difficult position since it is highly indebted with most of its debt in foreign hands and redenominated in a currency it has no control over. Even if it manages to produce primary surpluses this year – something that is highly probable if not certain – and in the foreseeable future, it will take a very long time before the Greek debt ratio reaches 90 percent of GDP, regarded by some as a sort of threshold, or lower. And this is under the condition that the country will borrow at low interest rates and the economy will grow with nominal GDP growth rates being equal or higher than the interest rate burden as a percentage of GDP.

It would have been better for Greece and others, including the IMF, if a good portion of the debt in EU hands had been written down in order to attain a much lower debt ratio, though it would have been very difficult for EU governments to consent to a haircut for obvious political reasons. Nevertheless, the EU’s finance ministers will be called upon in the next few months to decide on measures, other than a haircut, to slash the Greek debt ratio.

After all, the Eurogroup has committed to taking new debt relief measures next year to drive the Greek public debt-to-GDP ratio to 124 percent in 2020 from an estimated 128 percent or higher if the country produces a primary surplus and implements the agreed structural reforms. Since a haircut on the nominal debt held by EU governments and institutions will not be on the agenda, the alternatives are obvious: Cut the interest rates, extend the maturities, have the ESM assume a portion of the debt related to the recent bank recapitalization, and perhaps involve the EU structural funds earmarked for Greece through 2020.

The most likely scenarios are an interest rate cut on the EU bilateral loans (GLF), totaling about 53 billion euros and the extension of the maturities. Greece is paying a low interest rate on the GLF loans, estimated around 0.9 percent. Simulations show that a rate cut of half a percentage point would have a very small impact on the debt ratio since its cumulative effect does not exceed 1 percent of GDP or less than 2 billion euros. An interest cut to the EFSF loans is more complicated since the EFSF is rated and will likely be avoided. So, the bulk of the downward adjustment to the debt ratio should come from the extension of maturities.

Such a long extension of maturities will translate into a very small to negligible refinancing risk for Greece since the bulk of the debt will be pushed back for a decade or more. This should be put into context with the interest burden facing the country. Greece’s interest payments amount to 3.8 percent of GDP for this year and the EC estimates they will rise to 4.4 percent in 2014. Even if one assumes the expected new rate cuts will have a negligible impact on future interest payments, the interest burden is not unbearable. One may even argue that it is quite manageable, assuming the country returns gradually to its long-term growth potential.

This combination of very low to negligible financing risk for many years to come and a relatively low interest burden, along with increasing signs of economic stabilization should make many private investors, namely funds, more willing to tip their toe into new issues of Greek bonds from 2014 onward. It should also provide a good reason for the EU and the IMF to revisit and revise their analysis and definition of Greek debt sustainability.