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Sovereign Debt Restructuring: The Greek Challenge

Does the past dictate the future?

IMD Professor Carlos A. Primo Braga

In contrast to the usual great memories spent on the Mediterranean, this July will rather be remembered in a less sunny manner. It will go down in history as the first time that the irreversibility of the European Union's evolving monetary union,the Eurozone, was put in doubt by one of its founding members (Germany).

The Greek economic crisis – and the possibility of a Grexit – has fostered an intense debate about the future of the euro. The most recent outcome of this debate was the beginning of a new bailout negotiation, expected to amount to EUR 86 billion. In parallel with bridge loans from the ECB and the Eurogroup to address Greece's liquidity problems, this bailout is intended to support the Greek economy and to avoid the meltdown of its financial sector. Yet sentiments around it run deep.

The current situation in the Eurozone brings to mind the famous opening lines of Tolstoy's novel Anna Karenina: "
Happy families are all alike; every unhappy family is unhappy in its own way."

Similarly, the recent "solution" to the Greek crisis has left all parties involved unhappy for different reasons. For Greece, it underscored the limits of its "sophomoric" strategy, requiring a dramatic turnaround in its negotiating position from early July. Faced with the danger of a financial collapse, Greece ended up accepting even harsher conditions from creditors in spite of the results of the July 5th referendum (see Professor Reacts) that had given the Syriza government a mandate to resist continuing fiscal austerity. In short, the pain of the "capitulation" and the prospects of a new chapter of austerity cum reforms do not bode well for Greeks to take ownership of the upcoming bailout program.

For Germany, at first sight, the results seem to confirm the victory of the rules-based austerity "school of thought" as an answer to the Eurozone crisis. However, by mentioning a "Plan B" that would involve a temporary Grexit, Minister Schäuble hinted that one of the basic tenets of the monetary union, its irreversibility, is not set in stone. For some analysts, this was more a tactical move to underscore the exasperation of several creditor countries vis-à-vis Syriza's negotiating antics rather than a real alternative. Nonetheless, the ensuing debate revealed divisions between those that see the objective of an ever more integrated Europe as the ultimate driver of political decisions in the EU and those that believe that an imperfect monetary union cannot survive divergent fiscal trends. In short, it reopened the debate about the need for fiscal transfers (in the name of European solidarity) and more specifically the need for additional debt relief.

Dealing with debt – The Greek way

Greece has significant historical experience with debt defaults and restructurings. Since its independence in 1829, modern Greece has been involved in 5 defaults and/or restructurings of debts before the current crisis. To put things in perspective up to 2008, Greece spent roughly 50% of its independent life facing debt problems, while Argentina – the poster child among serial defaulters – although with a higher number of crises episodes, enduring 7, spent only roughly 33%of its sovereign history confronting debt crises (from 1816 to 2008).

Moreover, Greece stands out among current high income economies, as the only country that has defaulted twice, in 1894 and 1932, when its public debt surpassed 100% of GDP. Ironically, the other high income economy that also defaulted once this threshold was breached was Germany in 1918.

One could argue that Greece's historical experiences have limited relevance for the current crisis, since they happened amid nation-building efforts and followed Greco-Turkish wars. In this context, they resemble more the growing pains of an emerging economy with a significant proportion of their debt denominated in a foreign currency. There are some lessons, however, to extract. First, it is very difficult for countries with an excessive debt overhang to grow out of a debt crisis. Second, this is particularly true when the country lacks solid domestic institutions and faces a crisis amid a difficult external environment.

By 2010, Greek debt had already reached 130% of GDP at EUR 300 billion and its fiscal deficit was around 15.5% of GDP. It was clear that Greece was on an unsustainable debt path and a major adjustment cum debt restructuring was the most likely outcome. Still, creditors tried to keep appearances – in 2010 the IMF even released a study entitled: "Default in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely." This was done to curb concerns about contagion in the euro periphery in light of the Lehman Brothers experience.

Two years later, however, the largest sovereign debt restructuring ever became a reality. Private sector creditors had to accept a haircut on Greek debt of more than 50%: a debt relief in excess of EUR 100 billion. Moreover, official creditors stepped in with credits of longer maturity and with lower interest rates, diminishing the burden of debt servicing for Greece in a substantial manner. Still, things did not improve. The austerity drag on the Greek economy, combined with the poor implementation of structural reforms, pushed debt to 176% of GDP by mid-2015. The bad economic dynamics of the last few months and the escalating financing needs of the Greek economy suggest that this ratio will peak above 200% in the near future. Accordingly, a new debt restructuring is inevitable and the IMF became the first official creditor to recognize this reality.

The road ahead

The fly in the ointment is that the circumstances today are quite different from those that prevailed in 2012. The Greek debt is currently mainly a public sector affair, with roughly 80% of it being held by international institutions (IMF, ECB, and Eurozone mechanisms) and European governments. The good news is that the danger of contagion is limited, given the official characteristics of the holders of the Greek debt (relief is unlikely to create significant negative market spillovers) in a macro environment with high liquidity in view of the ongoing quantitative easing from the ECB. The bad news is that these creditors are typically much more skeptical of providing debt relief when they are directly involved.

The history of debt relief in the context of the Heavily Indebted Poor Countries (HIPC) and the Multilateral Debt Relief Initiative (MDRI) programs of the IMF/World Bank come to mind.* It took substantial external pressure and a long and complex process for multilateral creditors and bilateral donors to accept the idea of debt relief in the case of low income countries. The debate in the case of Greece, a high income economy, will be even more contentious. Still, the concept of tying future official debt relief to broad economic performance indicators including social expenditures, as in the case of HIPC/MDRI, is worth considering.

The reaction of official creditors at this stage, however, remains quite cautious. Germany, for example, has made it clear that the focus should be on the negotiation of the new bailout program and that outright debt write-down involving public creditors is against the rules of the Eurozone. Article 125 of the Lisbon Treaty is often invoked in this context as the non-bail-out clause of the EU. Needless to say, the legal interpretation of this clause is open to debate. But the reality is that the political willingness to consider further debt relief is in short supply.

Germany, for example, has already indicated that at best one could discuss a re-profiling (extension of maturities) of the debt once the bailout negotiations are successfully concluded. This, however, will only work if the grace period were to be substantially extended (e.g., 30 years for the whole stock of official debt). This will not be an easy sell in many European capitals. The alternative, however, is even worse since it will require a leap-of-faith concerning resumption of growth in Greece (sustained rates of at least 2% per year) in an environment characterized by consistent primary surpluses of 3.5% per year. In other words, the expectation that Greece will become a "new" Germany. To make things even worse, the lack of ownership of the reform program by Greek politicians further magnifies the chances of failure.

Former Citibank chairman Walter Wriston used to quip in the 1980s that "countries don't go bust." The current misalignment of expectations between creditors and the Greek government, as well as the refusal to face reality vis-à-vis the need for substantive debt relief, have put the Eurozone in a collision route that will reframe the definition of what bankruptcy means for a sovereign.

Carlos A. Primo Braga is Professor of International Political Economy at IMD, and Director of The Evian Group@IMD.

was the Director of the Economic Policy and Debt Department of the World Bank during 2008-10. This was the department that coordinated the HIPC and MDRI initiatives for the World Bank.

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