A major step towards a Greek compromise

- Finance Minister Varoufakis’s proposal provides a good basis to start discussions

by Zsolt Darvas on 3rd February 2015

 Bruegel.org

Following a week of fright after the Greek elections, during which various statements by the new Greek government have raised the spectre of Grexit, Finance Minister Varoufakis made a surprising proposal yesterday: the government will no longer call for a headline write-off of Greece’s public debt, but instead proposes to change the terms of current European loans to Greece, to aim for a primary surplus (much) smaller than the Trokia target and fight against tax evasion.

Abandoning the demand for a substantial haircut is a major step, because it was one of the crucial demands of Syriza during their election campaign. It was also a wise step, as an outright haircut is both unnecessary and also a no-go for euro area lenders (see here). Any level of debt is sustainable if it has a very low interest rate, and European loans to Greece carry very low interest and already currently have super -long maturities.

Exchanging current EFSF (€141.8bn) and bilateral (€52.9bn) loans to GDP-indexed loans is a great idea (see my 2012 blog with this proposal here and the full paper with details here). If it is done in a neutral way, it will not lead to a net present value debt reduction (as we argued here), but it would certainly serve as insurance against unexpected GDP shocks: if the economy deteriorates further, there will not be a need for new debt restructuring, but if growth is better than expected, official creditors will also benefit. There are many different ways to specify a GDP-indexed loan and it would be possible to design it in a way which leads to a net present value reduction for Greece, yet I’m not sure euro-area partners would be very open for that.

Rolling over the bonds held by the ECB and national central banks (NCBs) was found to be legally prohibited: see President Draghi’s letter concerning the NCB holdings here; the same applies to ECB holdings. However, Greece could take a new, very-long maturity ESM loan to buy back ECB/NCB holdings, in which case the maturity transformation would grant major benefits to Greece (see our discussion of this issue with Neil Unmack in the comment section of our blogpost). However, this would require a new ESM programme that the Greek government does not seem to like much. Unfortunately, the total outstanding volume of ECB/NCB Greek bond holdings is not known in a ‘transparent’ Eurozone; my guestimate is €27.5bn.

Beyond these “debt swaps”, one could go further and take Greece out of the market until 2030. Even if the currently very high market interest rates for Greece should fall, they will likely remain too high. Moreover, it would be worthwhile to take an ESM loan to repay the IMF early (similarly to Ireland early repayment of IMF loans last year, as the Irish market borrowing rates were well below the IMF’s lending rate). The IMF loans carry a much higher interest than ESM loans: the IMF’s lending rate is 200/300 basis points over the average short-term interest rate of the SDR currencies (see here). In contrast, the ESM lending rate to Greece is practically equal the ESM’s average own borrowing costs, which could be around 0.2 percent per year currently. Yet again, an ESM loan requires a new ESM programme.

Lowering the primary balance target should also be possible. The current Troika programme foresees a 4.5 percent of GDP primary surplus, while Minister Varoufakis suggested a 1-1.5 percent value. There should be an agreement somewhere in between.

When exchanging current EFSF and bilateral loans to new loans (possibly GDP-indexed), maturities should be further extended. This measure would benefit Greece, but would not incur net present value losses for euro-area creditors (as we argued here).

Taking together all of these measures, the impact on the debt/GDP trajectory should not be so large, even if the primary surplus is lowered (I will publish a blog post with my calculations later this week).

Let me come to the more fundamental question: why should euro-area partners offer such concessions to Greece, after so many concessions in the past? I see three major reasons.

First, while Greece was primarily responsible for the fiscal mess that necessitated the bail-out in 2010, the Greek financial assistance programmes were designed by the troika of the European Commission, ECB and the IMF, and were approved by euro-area member states, so the lenders also have a responsibility for programme failure. While Greece did not meet a number of conditions, lenders are responsible for basing the initial programme on overly optimistic assumptions and for delaying private debt restructuring. The uncertainty related to the sustainability of Greek public debt and the consequent uncertainty in Greece’s euro area membership in 2010-12 were major negative factors behind the collapse of Greek GDP.

Second, until the delayed debt restructuring in April 2012, official loans were used to repay maturing privately held debt (which, by the way, was mostly held by non-residents in end-2009; see Silvia Merler’s post on this). According to the calculation of Macropolis, only €27bn out of the €227 disbursed official loans was used to finance Greek government expenditures: the rest was used to pay interest, repay maturing debt, recapitalise banks (which was needed party due to their large government bond holdings, but also due to the collapse of GDP) and support the debt restructuring. While I have not done the math on this issue by myself, one can easily check that this calculations is likely correct: according to the European Commission, Greece’s primary deficit in 2010-13 was €40bn in total, which includes some bank rescue costs and also the first four months of 2010 when the financial assistance programme was not yet in place. Therefore, the total primary deficit excluding bank recapitalisation between May 2010-December 2013 was likely well below €40bn. (There was already a primary surplus in 2014.)

Third, a Grexit would be a catastrophe. Greece would lose more than euro-area partners.Greece would enter another deep recession, which would push unemployment up further and reduce budget revenues, requiring another round of harsh fiscal consolidation: exactly what Syriza wants to avoid. Euro-area partners would also lose most of their official and private claims on Greece. The irreversibility of the euro would also be refuted. While it is probable that many of Syriza’s election promises cannot be fulfilled, the new Greek government cannot backtrack on all that they promised in the campaign. If they are forced to do so, Grexit could still be a possibility.

Therefore, I suggest that European leaders consider the draft plan of Minister Varoufakis seriously, and the Greek government should put aside its reservations for a new ESM programme. Certainly, European partners cannot accept everything and many election promises have to be reconsidered. But in my view, Greece made a good start by abandoning its earlier haircut demand, and reasonable compromises should be found on the other issues, including helping Greek debt sustainability without causing a net present value loss for euro-area creditors. In the meantime, the European Central Bank should keep the Greek financial system afloat: as argued by Karl Whelan, there are no strict rules on related issues, but discretionary decisions by the ECB Governing Council.

http://www.bruegel.org/nc/blog/detail/article/1561-a-major-step-towards-a-greek-compromise/