European countries have faced an Econ 101 tri-lemma for years: the impossible coexistence of fixed exchange rates, no capital controls and independent monetary policy. This led to the creation of the euro. During the crisis, emerged an institutional tri-lemma: no exit, no default, and no bailout. It ended with the ongoing (lengthy and painful) overhaul of European institutions. As negotiations on Greece's bailout enter their third round, this Record focuses on the new Greece Tri-lemma: no new funds, no restructuring of public/official debt, and no exit.
Background: in spite of the Private Sector Involvement (NYSEARCA:PSI) carried out earlier this year, Greece's public debt is still too high and should stand around 185-190% of GDP in 2013. The target of a public debt to GDP ratio of 120% as early (yes, early) as 2020 seems unreachable.
According to Natixis' Europe team, The IMF sticks to the line that the public debt stock target should be 120% of GDP in 2020, implying the Eurozone countries would have to accept writing-off a portion of their loans to Greece. On the other hand, the Eurogroup, led by Germany, proposes a two-year deferment (to 2022) to reach this target, so that alternative measures than Official Sector Involvement (OSI) could be implemented.
Alternative measures include reducing the interest rates on the European loans to Greece, deferring interest payments on loans from the EFSF by 10 years, and pushing the target date for public debt back. The ECB and the National Central Banks could also forego the profits earned on their Greek bond portfolios (it is estimated that ECB bought GGBs for around 83% of face value). Those measures are clearly too small to change the current debt trajectory. Another option is to allow Greece to borrow funds in order to buy back bonds at a discount, but this is not economically efficient. As Rogoff wrote in 1989 (NBER 2850), "Sovereign Debt Repurchases are no cure for overhang: unilateral buybacks make sense for a country only when its alternative investments are extremely poor." In addition, the benefit of bond buybacks can easily be offset by price increases once the buyback is announced. Yet, the operation could reduce the debt load by 20% of GDP and would also be beneficial for investors that took part in the PSI, as their losses have been written down with very low prices.
Would this be enough to avoid an Official Sector Involvement (OSI)?
- There will be some delays but the next tranche (€44 bn) will probably be disbursed in early December (no new Funds);
- For domestic political reasons (Germany, notably) it is said the OSI will be postponed. There might also be an economic rationale for that: a debt write-down should be a one-off event that takes place once the conditions for debt sustainability (at least a significantly positive primary surplus) are met by the debtor country. There is a hesitation (economic and political) cost with higher net present value loss, but it is much smaller than the credibility loss that would come with unsuccessful write-offs;
- The fear of a Greek exit suggests otherwise: an early partial write-off would show the commitment of European governments to keep Greece in the euro. It would probably come with a severe loss of sovereignty in Greece.
Forget about the menu of small-adjustment measures that are likely to come out of the next meeting. The road will be long , the political cost will be high, and the Eurozone will not be able to accept anything but an official (non-IMF) debt write-off.