The Silver Bullet | Greece: More Melodrachma, No Default

Negotiations on Greek debt are once again about to take a tortuous turn. Today, the Eurogroup meets to decide on completing its second bailout review. In a tradition perpetuated since the start of the crisis, we believe we are unlikely to get a clean solution.

At the crux of the problem is a longstanding disagreement among creditors. On the one hand the IMF – after dedicating 18% of its current total credit outstanding to Greece – now wants out. On the other hand are European creditors, split into two fronts. France, Italy and the ESM have expressed readiness to intervene and potentially replace the IMF, while Germany requires its participation. Watching the events unfold is the ECB, which previously flagged the possibility of including Greek debt in QE has recently taken a more neutral stance.

Greece stands again, alone, at the centre of a large chessboard. If negotiations were only about Greece, a country of 10m people and an economy the size of Milan or Düsseldorf, then these would have already been completed a long time ago. But it is clear to everyone that the approach to dealing with Greece entangles a much wider array of interests than solving the Greek crisis itself – and can be seen as a blueprint for future crises. Understanding the next steps can reveal insights on Europe’s next steps towards, or against integration.

The Situation: Greece needs to conclude its second bailout review to access the next tranche of aid from creditors. The government faces €7bn of debt redemptions in July. Beyond that, the outlook for growth and debt sustainability remains uncertain. The latest IMF projections forecast debt to GDP falling below 170% over the next four years. However, these projections are much less optimistic than previous ones. Achieving solvency will depend on growth and political stability: even having delivered on reforms and privatisations so far, it is unclear how long the Greek people will be able to take more tightening on pensions and public services. Despite recent improvements in growth, one out of two young Greeks remains unemployed.

The Pawn: Tsipras’ Syriza government. After slightly over a year in government, a ‘No’ referendum and many other ultimatums to creditors, Greece’s government led by PM Tsipras is dwindling in consensus, and seems to be increasingly saying yes to creditors’ demands. PM Tsipras has long been calling for a political solution to the Greek debt problem, including at the recent Euro summit in Malta. So far, however, his requests have been ignored by creditors, and his promises are starting to appear unrealistic to voters: Syriza has lost consensus and now stands 15 percentage points below New Democracy in polls.  This means a clear loss to the opposition in the case of new elections, and an incentive for Mr Tsipras to cave in to further requests, as hard as they may be on the Greek population.

The Bishop: the IMF. A lot has been said about the IMF’s involvement in Greek aid. The numbers speak for themselves: Greece has been by far the biggest use of IMF balance sheet over the past decade. Today, we know a lot more about the backstage details on how the IMF got so deeply involved in Greece. We know for example that Olivier Blanchard, IMF chief economist at the time, warned that the aid plan could go awry with an L-shaped recovery. With hindsight, the key issue remains that of solidarity. Perhaps the IMF overestimated the willingness of other creditors to give Greece debt relief. It also underestimated the reaction of EM countries, which have been digging their heels against giving additional funds to Greece, where pre-crisis the unemployed earned more than the average salary in China or Russia. Admittedly, the fund was also wrong on austerity measures. But since last year, the IMF’s stance on Greece has taken a U-turn, arguing for softer budget deficits, less austerity and openly asking for debt relief. In its latest press briefing from February 7, the fund recommends a 1.5% rather than a 3.5% primary budget surplus, combined with implementation of labour and product market reforms. But it also warns that “Even with full implementation of these policies, Greece cannot grow out of its debt problem. European partners need to provide further debt relief, in addition to the generous relief provided thus far, to put Greece’s debt on a sustainable downward path.”

The Queen: Germany. Germany has remained steadfast on its demands for Greece: further policy measures and no debt relief. Chancellor Merkel and Finance Minister Schäuble’s firm stance comes ahead of German elections in September. Merkel’s CDU and CSU coalition has lost considerable ground to Schulz’s SPD party. The SPD party has gained 10pts in polls this year and is now almost neck-and-neck with the CDU and CSU coalition. The SPD’s stance that a Grexit should be avoided, may give the CDU and CSU some room to manoeuvre on negotiations with Greece. However, Merkel and Schäuble are likely to continue their tough rhetoric on negotiations so as to win support of the German people, more than half of whom favoured Markel’s stance on Greece during the depths of the Grexit crisis in 2015. But beneath this political dust, Merkel and Schäuble will ultimately support a deal to maintain the integrity of the Euro, the benefits of which to Germany’s economy outweigh the cost of debt relief to Greece. According to a McKinsey report, Germany has been the largest beneficiary from the currency block: out of €330bn in additional growth in 2010 alone, McKinsey estimates Germany received half at around €165bn (equivalent to 6.6% of its GDP), nearly two-thirds of which came from improved competitiveness from a lower currency level.

The Rook: the ECB. The question of potential inclusion of Greek debt within the ECB’s quantitative easing programme has been debated by Mr Tsipras and Finance Minister Tsakalotos frequently since last year. The ECB could have a powerful impact in lowering yields on the little privately-owned Greek debt outstanding. However, it is slow-moving. And while Mr Draghi had said last year that “when the time comes we will examine independently the issue of the debt sustainability”, a recent discussion devolves to the IMF and European creditors any analysis on debt sustainability. It is unlikely, in our view, that the ECB will take an independent step towards purchasing Greek debt, before an agreement is made among creditors and the debt is deemed sustainable.

The Knight: the ESM. European Stability Mechanism head Regling recently wrote in the Financial Times that the Luxembourg-based fund stands ready to help Greece. The fund argues it is ready to extend loans to Greece at a low cost, making its debt sustainable. However, it is perhaps a little optimistic on debt relief, arguing that “the solution for Greece lies not in additional debt relief, but in the government implementing reforms so as to avoid delays in the issuing of the next tranche of the ESM loan.” This may be true in the near term, but as the IMF points out, a plan for debt relief is also necessary.

We see three ways the game can unfold:

Base case: We are likely to see more negotiations, with the Greek government trying hard to fight against further measures and creditors agreeing to disburse small amounts of further aid until year-end. The IMF could stay in symbolically, but with limited further financial contribution. Ultimately an agreement will be reached, allowing Greece to meet its July payment and avoid snap elections.

Best case: There could be a quicker agreement on the conclusion of the second review and a plan to restructure Greece’s debt through extension/interest reduction later on. An election of a Merkel-Schulz coalition would favour this outcome, with Schäuble becoming less stringent on conditionality.

Worst case: This is the case when the current negotiating parties fail to reach an agreement, triggering snap elections in Greece. Syriza is likely to fall, with New Democracy taking over as the new government to re-start negotiations with the creditors. Ultimately we are likely to see an agreement, but only after substantial volatility with snap elections just before the July payment and at the same time as the French elections. The final agreement could include more austerity measures, which will hurt growth in the medium term. There is also unlikely to be a clear agreement on the roadmap to debt restructuring.

The optimal solution: reforms today and a flexible debt framework for a stronger Eurozone tomorrow. Greece needs comprehensive debt relief, not a piecemeal approach with insufficient extend-and-pretend measures. Standard debt sustainability analysis on Greece doesn’t take into account European solidarity. With it, Greek debt can be sustainable. The question is about how to institutionalise debt flexibility, or debt relief.

We have long argued that not only Greece, but other parts of our financial system need a more flexible approach to debt. The current debt super cycle started in the 1960s, when populations were growing, technology was inflationary, debt levels were low and there was plenty of room to lower interest rates. Today we no longer have the luxury to perpetuate a fixed income debt-based financial system: debt relief must be incorporated into financial instruments. This has already happened in the case of contingent convertibles for banks, which now amount to €173bn and around 7% of banks’ total capital. In the case of sovereign nations, such flexible instruments have been tested (e.g. GDP-linked bonds in Argentina, Ukraine) to compensate creditors for facilitating a financial restructuring.

In a currency union, where monetary policy is one-size-fits all, the role of fiscal stabilisers is even more crucial, especially for smaller countries. In the case of Greece, a substantial interest reduction and maturity extension are necessary, of at least 30% of net present value, to restore sustainability. But Eurozone countries, Germany in particular, should also think harder about institutionalising fiscal flexibility for their smaller members – who benefit from little flexibility in monetary policy.

The first option would be to introduce conditional fiscal transfers through a large EU/Eurozone budget, as the heads of Germany’s and France’s central banks have suggested. This is a political choice, however, and may be subject to decision making at each point in time. The second is to introduce a common Eurozone debt framework. This had been discussed in many versions: e.g. with Bruegel’s red/blue bond proposal, or most recently with a plan to bundle national debt in a common bond. There are political obstacles to bundling or issuing common debt too, and this option remains far from achievable at the moment. The third way would be to introduce flexibility at the instrument level, issuing government bonds with coupons linked to future growth rates. This presents some practical difficulties, but it has been done before. Growth-linked debt has been used before in emerging markets, and both the IMF and the Bank of England have proposed extending the framework to other countries.

Conclusions:

1. There’s no clean solution in sight for Greece this year, but more extend-and-pretend.
2. However, we are starting to see more common ground among creditors and some progress on debt relief.
3. Our base case scenario is for a small IMF contribution and a temporary deal until German elections. Later on, debt relief will depend on German (and Greek) politics: a Merkel-Schulz coalition in Germany (and a New Democracy government in Greece) could pave the way to finally solving Greece’s debt problem.