Several Ways to Chip Away at Greece's Debt Mountain

The Wall Street Journal

Euro-zone finance ministers admitted for the first time this week that they must reduce the burden that Greece's enormous government debt is placing upon the country's economy.‪

Easier said than done.

The ministers said Monday they will explore "steps to reduce the cost of debt-servicing and means to improve the sustainability of Greek public debt."

A "sustainable" debt burden is one that a debtor will be able to repay in full and on time, and that will eventually start to fall as a proportion of economic output. It's a term of art, rather than science. The International Monetary Fund continues to claim that Greece's public debt, forecast to rise above an enormous 160% of gross domestic product, is sustainable—even in the face of financial market incredulity.

While the ministers' statement suggests some efforts to relieve the weight of Greece's debt burden, it doesn't commit them to reducing Athens' €350 billion ($495 billion) debt stock.

The minimal option appears to be for euro-zone governments to further reduce interest rates on their bailout loans to Greece, as they seek to extend the maturities of bonds as they come due. The benefits to Greece could be boosted by cutting interest rates paid to private bondholders—for example, by swapping maturing bonds for new bonds with lower interest rates—and extending maturities to, say, 30 years, instead of seven.

The drawback to this approach is that it would continue to address Greece's debt as if it were a liquidity problem, and do little to convince skeptics that the government's debt burden will eventually return to a downward trajectory. Such an approach wouldn't be costless either, since rating agencies have made clear that they would view any effort at extending bond maturities as putting Greece in a "selective default."

"We are at the point where an interest-rate reduction and maturity extension are necessary, but no longer enough to make Greek debt sustainable," says Sony Kapoor, managing director of Re-Define, a financial think tank.

So what if governments go for a more radical approach also under discussion by European officials, and go forward with a plan to reduce Greece's debt?

Options under this plan would aim to capture, for Greece's benefit, the discount to face value at which the country's bonds are now changing hands. This could be achieved through bond buybacks for cash, or through bond exchanges. Both options can deliver the same economic benefits to Greece—but there are technical, accounting, legal and other differences between the two that could be significant.

One proposal under discussion is for the European Financial Stability Facility, the euro zone's bailout fund, to help Greece go into the market and buy back bonds now trading at a discount. This might not trigger any default calls from ratings agencies—but it might not do much good for Greece. In the barely traded market for Greek debt, the entrance of a big buyer would instantly drive up prices, and significantly limit the scope for debt reduction.

            Some debt could be purchased from the ECB, which stepped in last year to buy Greek government bonds. But that wouldn't be help much either: The estimated €48 billion (face value) that the ECB holds was bought on average at more than 85% of face value. With such bonds now trading at about 50% of face value, buying from the ECB at cost—almost nobody argues that the ECB should take losses—would yield no more than €8 billion of debt reduction from a €350 billion burden.

For Greece's debt to be widely seen as sustainable it needs to be cut by about a half, analysts say. Picking off a few willing sellers could shave a few billion euros from the burden—but really not address debt sustainability. Some analysts argue that the only way to achieve a worthwhile debt reduction is to move away from the idea that creditor participation must be voluntary. "It's going to have to be a wholesale coercive buyback or it will be pointless. Opportunistic buybacks in the market would simply bid up the price without increasing debt sustainability," says Mr. Kapoor.

That would entail putting a price into the market—say 50% to 60% of face value, and telling bondholders to take it or leave it. Those who decide not to take up the offer could find their bonds not serviced, and since a vast majority of Greek bonds are issued under Greek law, they could find it difficult to pursue legal claims.

A buyback could be handled by the EFSF directly—or more likely by the Greek government, using EFSF funds. Financing the buybacks would require the EFSF to raise more than €100 billion in the bond markets, perhaps tapping demand for top-rated paper from sovereign-wealth funds (lhydhak:A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments. Sovereign wealth funds invest globally).

This two-step process could be turned into a one-step process with a debt exchange, under which holders of Greek bonds are encouraged to swap their existing bonds for bonds with a lower face value. The replacement bonds could be issued by the EFSF or Athens with a "credit enhancement"—guarantees of repayment at maturity and some interest payments.

Bond exchanges could be more attractive for bondholders than debt swaps in some circumstances, potentially reducing the write-downs that some investors would have to make.

Credit enhancements could be used to make the exchange more attractive for investors. But they increase the costs to Greece, since Athens would have to finance them through purchases of top-rated securities that could be cashed in to guarantee repayment of capital or some payments of interest. "Credit enhancements should only be given in return for large-scale debt reduction," says Adam Lerrick, a Washington-based specialist in sovereign debt restructurings.

A coercive buyback or debt exchange both risk declaration of a full default, and a likely trigger of a "credit event"—which means payouts to holders of insurance bought in the credit-default-swap market. Euro-zone governments have argued that both are undesirable; proponents argue that if a default leads to a big debt reduction and debt sustainability, Greece's rating would be affected only for a short time before it rose rapidly again. Meanwhile, the net amount of credit-default swaps outstanding is tiny compared with the outstanding stock of Greek debt: $4.8 billion, according to the DTCC Trade Information Warehouse.

Euro-zone governments have options in front of them that could return Greece to debt sustainability. They could, as their record suggests is more likely, take a more conservative approach and leave hanging over the euro zone continuing questions about whether the country's debt will be repaid in full and on time.

Write to Stephen Fidler at stephen.fidler@wsj.com