Next Up for Greece: How to Shrink the Debt

Political talks to begin after first bailout review is done

The Wall Street Journal

By VIKTORIA DENDRINOU

Jan. 14, 2016 1:44 p.m. ET

Greece’s creditors are expected to start talking soon over an issue that has been looming over the eurozone since 2010: cutting the country’s mountainous debt burden.

Greece already sliced its debts to private lenders through a bond swap in 2012. But that wasn’t enough. Now, most of its debt is owed to other eurozone governments, which have conceded Athens needs more relief.

The debt talks won’t begin until after still-difficult negotiations over steps Greece must take, including pension changes and budget cuts, to complete the first review of its latest bailout package for up to €86 billion ($93.4 billion) agreed to last year.

Jeroen Dijsselbloem, the Dutchman who presides over meetings of eurozone finance ministers, said Thursday that once there is agreement on that, “then we will start political debates on debt sustainability.”

But while the creditors—the eurozone and the International Monetary Fund—broadly agree on how they could go about cutting Athens’ debt, they will likely lock horns over how much relief the country will need.

The IMF wants Greece to get a substantial reprieve and foresees a gloomier outlook for its economy. Most eurozone governments balk at large-scale debt relief, and the bloc’s institutions have been more optimistic about Athens’ economic prospects.

Another dispute is likely over the timing. Creditors worry that granting Athens all the debt relief upfront could tempt it to be careless with its finances and slow reforms. But tying relief to future performance would also meet opposition from the Greek government and raise questions for investors.

A debt deal for Greece could have large implications for markets still scarred by the restructuring four years ago.

Crucially, debt relief is also a condition for the IMF to get on board with Greece’s bailout and start doling out fresh loans. Several eurozone countries—led by Germany and the Netherlands—have demanded IMF participation alongside their own.

Until now, the key official measure of debt sustainability has been total debt as a proportion of gross domestic product. Greek debt was expected to reach 194.8% of GDP by the end of last year, and will peak at just below 200% by the end of this year, according to European Union forecasts published in November.

Eurozone leaders have acknowledged that the level of Greece’s debt is too high, but have ruled out cutting its face value, an option favored by the IMF and the Greek government.

Instead, they argue that debt sustainability would be ensured if annual gross financing needs—the money the country must raise to cover its deficit, interest payments and maturing debt—remain below 15% of GDP annually, a threshold the IMF has deemed sustainable.

When the needs exceed 15% of GDP, lenders will reduce them through “re-profiling”—pushing debt maturities and interest payments out into the future, potentially for decades. This could be done by capping interest payments, extending debt maturities and linking debt repayments to economic growth, according to a paper drawn up by the eurozone’s bailout fund—the European Stability Mechanism—-and seen by The Wall Street Journal.

If designed properly, a deal that doesn’t reduce the face value of Greece’s debt could still make the burden sustainable, officials and some analysts say.

“Without a nominal haircut, [reprofiling] could reduce uncertainly and be sustainable,” said Zsolt Darvas, a senior fellow at Bruegel, an independent Brussels-based think tank.

Still, to determine Greece’s future gross financing needs, creditors must agree on a set of key assumptions about the economy, including how fast it will grow, what deficits Greek governments will run, and what kind of debt Athens will issue in the coming years.

Eurozone officials and analysts warn this will be difficult given that the IMF will likely opt for significantly gloomier assumptions than the European creditors.

A way to partially bypass this problem could be to link some debt repayments to GDP, an option mentioned in the ESM paper. That way Greece will repay more debt if its economy is doing better and less if it isn’t.

Still, the risk of Greece becoming complacent if it gets all the debt relief upfront will also weigh on discussions. To deal with this possibility, officials say lenders will most likely tie any deal to economic overhauls and fiscal discipline.

One way to do this would be to grant Athens some relief immediately and tie the rest to longer-term monitoring and goals until the bailout expires in 2018 or even later, officials say. Meanwhile, tying part of the future relief to how the economy is doing should account for any unforeseen shocks.

But prolonged monitoring and fiscal restraint is likely to be strongly resisted by the Greek government, eager to free itself from the bailout regime it has lived under since 2010.

Write to Viktoria Dendrinou at viktoria.dendrinou@wsj.com