Solutions from European mechanism can help manage debt, lead to growth

Greece is likely to be given an extension for the repayment of the loan provided by several eurozone countries and the International Monetary Fund at the European Union summit this week. However, this is not going to be enough for the country to avoid the restructuring of its public debt in coming years if it fails to get its economy growing again and reduce the sheer size of its public debt. Undoubtedly, it is different for Greece to have to pay over 70 billion euro annually in 2014-15 instead of, let’s say, 15-30 billion per year over the same period. So extending the maturity of the balance of the 110-billion-euro loan so as to repay it in 10 years’ time provides a reprieve but it does not change something very important before that. The country will have to borrow some 60 billion euros from the markets to cover its estimated borrowing needs from April 2012 through 2013. This is in addition to the remaining tranches from the 110-billion-euro loan, amounting to a total of 24 billion in 2012 and 8 billion in 2013. Whether this is possible remains to be seen although the odds are against Greece at this point. Still, the country will have to make an effort to get out of this vicious cycle by adopting a comprehensive package of measures and some more innovative techniques to spur growth and reduce its public debt-to-GDP ratio, which is the biggest impediment to accessing world markets. A month or so ago, we made a reference to financial engineering as a means of cutting the country’s public debt. Last week, we referred to the importance of cleansing the local banks’ bond portfolios in order to delink from the state’s public finances and convince investors to recapitalize them. This way it will be easier for them to provide credit to the private sector and help the economy grow again. We would like to put the two proposals together since they could have a common denominator: the EFSF. For those who are not aware of this, the European Financial Stability Facility (EFSF) is a limited liability company based in Luxembourg and headed by Klaus Regling, a former German Finance Ministry official who has also held high-level positions at the European Commission and the IMF. The EFSF will finance the loans by issuing bonds, notes, commercial paper, debt securities or other financing arrangements. The latter will be backed by unconditional and irrevocable guarantees from existing eurozone member states. Participating countries will provide guarantees up to 440 billion euros. The relative contribution of each country to the paid-up capital of the ECB will be used in the allocation of guarantees. But any loan will have to be covered by AAA guarantees or by cash. This reduces the size of the loans it can provide since only six eurozone countries have an AAA rating, namely Germany, France, the Netherlands, Austria, Finland and Luxembourg. Taken together, these six countries account for a little over 58 percent of all the guarantees of the EFSF. If this ratio is applied to the upper limit of 440 billion euros of the guarantees, this takes the maximum effective lending to 255 billion euros. If one adds the 60-billion-euro assistance from the EFSF and adds to this an additional 50 percent from the IMF, this raises the total to 473 billion euros instead of the 750 billion widely advertised. Coming back to Greece, we would refer to the first proposal, which aims to reduce the public debt. Under our scenario, the EFSF could provide relatively cheap financing to Greece so the country could buy back its bonds acquired by the ECB during its market operations in the last six months or so. The ECB is estimated to have bought Greek bonds worth 40 billion euros in nominal value and approximately 28 billion in actual value. By selling back these bonds to Greece at the price of acquisition, the country saves some 12 billion euros because it has these bonds in its books more or less at par. Of course Greece does not have the money to do so. That’s where the EFSF could step in and provide the necessary financing. You may say 12 billion euros in debt reduction is not enough. You may be right, but if one adds the 10 billion euros from the 110-billion-euro loan earmarked for the recapitalization of Greek banks, the total goes up to a more respectable amount of 22 billion euros. Getting back to the second proposal to free Greek banks from the burden imposed on them by the Greek fiscal mess, one can envision something similar to that which the EFSF aid provided to Irish banks. Local banks could be asked – i.e. by the ECB – to recognize all of the losses related to their holdings of Greek bonds and report more accurately their nonperforming loans and take the appropriate provisions. The EFSF could provide bridge financing to Greek banks on the assumption that recapitalization would allow them to reaccess wholesale funding markets. Of course, one may argue that such funding may not be available if Spain joins Greece, Ireland and later Portugal in tapping the EFSF since its maximum lending capacity is around 473 billion euros. However, there should be more than 300 billion euros available if Spain does not join and this is the most likely scenario. Greece is not likely to make it if its economy does not grow and does not find ways to reduce the public debt-to-GDP ratio. Taking advantage of the EFSF to do both in the way described above may not solve the problem but it would definitely help.

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