By Daniel Gros
The main focus of this weekend’s extraordinary meeting of EU leaders was Libya – not the Eurozone debt and banking problems (Van Rompuy 2011, European Council 2011). There was informal agreement, however, on the Eurozone debt issue and it confirms a trend that emerged 2010. In short, it is: “No default will ever be allowed, but all bailouts will be preceded by tough talk.”
This general direction has now been clearly set. It will take a major disruption to make the EU convoy change track.
What has been agreed? More money at cheaper rates
The soft conditions came in the form of:
- Restructuring of the official debt of Greece for which the maturity was extended to 7.5% and the interest rate reduced to 5%;
- Increasing the funding capability of the European Financial Stability Fund (EFSF) to the €440 billion originally foreseen (through an increase by the guarantees given by the AAA rated countries, especially Germany).
These parts of the deal might be summarised as “more money at cheaper rates”.
Apparently it was also agreed that EFSF might not only provide credits to countries which have lost access to the markets, but could also directly buy the government bonds of these countries. It is difficult to see the difference between primary market purchases of government bonds and providing credit directly to a country. This part of the agreement will be of limited value unless the condition (EFSF programme) is relaxed, as it well might be in future.
The trend: Tough talk and soft conditions
This weekend’s meeting marks the third time that Germany has talked tough but then caved in when financial markets became nervous. The really tough talk which initiated the latest round of market nervousness came late in 2010 in the form of an agreement between France and Germany, which was then enshrined on 28-29 October 2010 by the European Council whose “Conclusions” (i.e. the official statement of what was agreed) stipulated that:
- Financial support from the European Stability Mechanism will be subordinated to a prior “sustainability test”.
- New bond issues should carry collective action clauses (CACs) which render is easier to negotiate a restructuring or rescheduling, should this become necessary.
This sounded tough, but the “sustainability test” will remain a paper tiger.
The litmus test of any such test will be Greece. Most independent observers and investors assume that the public debt of Greece today is not sustainable. However, the official story is completely different. The IMF/EU/ECB mission has already published its own sustainability assessment with a clear conclusion – there is no problem of sustainability.
This optimistic stance of the IMF/EU/ECB troika is not surprising. These institutions could not have started the rescue programme if they had not come to this conclusion.
Even apart from the specifics of the Greek case it is clear that any rescue programme will be structured in such a way that it yields a sustainable path for public finances.
- To change the judgment that the public finances of the country in question are not sustainable after all would constitute an admission of defeat or, worse, the admission of an error in judgment. No official institution will ever admit this.
- Even if the Greek programme goes off track the official reaction will have to be: “there have been temporary problems, but a new programme will bring public finances back to a sustainable path”.
Basis of the sustainability calculation
In Greece’s case, the sustainability calculations of the IMF/EU/ECB are based on three simple assumptions:1
- The country can sustain a primary fiscal surplus of 5.5 % of GDP indefinitely,
- The growth rate of nominal GDP will be on average at least 3.5 %, and;
- The interest rate is at most 5.5 %.
Under this combination, the critical debt/GDP ratio will start to decline around 2013.
Problems with the sustainability calculation
There are three problems with this rosy calculation.
- Most observers would of course doubt that the Greek body politic can sustain indefinitely a primary surplus of 5.5 % of GDP.
But this is what the Greek government promises; the Troika’s sustainability assessment thus accepts it as an assumption.
- Similar doubts apply to the interest rate assumption (at most 5.5 %).
It is highly unlikely that private investors will buy bonds carrying such an interest rate.
The key issue here is a bit technical. According to the Leaders’ informal agreement, new bonds issued after 2013 would contain “collective action clauses”. These clauses (CACs to connoisseurs) are baked-in contractual conditions that make rescheduling easier. Since “rescheduling” means “partial default” from the investors’ perspective, CACs are worrying to private investors – even more so since about half of Greek public debt is “official” (i.e. own by the Troika) and all of this will be senior to private debt. In plain English, this means that official debt-holders get to jump to the head of the re-payment queue if things go wrong. Private investors who think all this through – and who fail to share the Troika’s faith in the three assumptions – will demand an interest rate that compensates them for the probability of rescheduling losses.
- The agreed size of the post-2013 Greek programme may well have to increase.
The interest charge on the existing €110 billion programme for Greece (based for now on bilateral credits, but later to be rolled into the new facility to be called the European Stability Mechanism, ESM) has been lowered to below 5.5 %, the interest assumption has also received official approval. And given the logic discussed above, private investors will shy away from Greek debt and the ESM will have to take up the slack.
- It is likely that post 2013 the size of the Greek programme will have to be increased until almost all Greek public debt will have been refinanced by the ESM.
Since Greek public debt already amounts to over €300 billion, the size of the ESM will have to increase after 2013. The Greek package alone is likely to require about 60% of its financing capacity. But this is not the end of the problems.
Once most Greek public debt has become official debt, a whole new game starts. At this point restructuring of private debt is no longer an option – the private lenders will have already backed out. The collective action clauses that were so cleverly included will be irrelevant. From this point onwards the ESM can only restructure its own claims on Greece.
Restructuring in this situation would mean European taxpayers taking the hit in terms of longer maturities and lower rates. At that point, expect more of the same, i.e. tough talk and soft conditions.
On 11 March the European Council has once more decided to kick the can down the road. Once again they have failed to think through the consequences of their actions from the perspective of the markets. They failed to think through what this weekend’s decision will mean for the options they will face in the future.
Having come this far it becomes very difficult to change direction. All our leaders can do now is to hope that the road will take a decisive turn for the better; and that the new ‘Pact for the euro’ helps them avoid future accidents.
Van Rompuy, H. (2011). “Remarks by Herman Van Rompuy President of the European Council at the press conference following the Informal Summit of the Heads of State and Government of the Eurozone.”
European Council (2011). Conclusions of the heads of state or government of the Euro Area, 11 March 2011.
1 A “primary” budget surplus (i.e. not including interest payments on the debt) runs down the debt/GDP numerator, GDP growth runs up the denominator, and interest payments run up the numerator. Sustainability means that the debt/GDP ratio doesn’t grow forever.