Greece

Bottom Line: January provided a healthy reminder that debt overhangs do not go away. Eventually they undermine the economy and politics of the debtor country. What lessons will be learned? Sovereign debt is back on the front pages of the papers, and there is a renewed focus on the global rise in indebtedness. The new Greek government’s call for a substantial easing of its debt burden has been given the cold shoulder by European leaders and may be the largest obstacle to a deal keeping Greece in the eurozone. At the same time, Ukraine announced it would begin negotiations with creditors, leading bond prices to plunge on expectations of a restructuring. Falling oil prices are raising concerns about debt sustainability in Venezuela, Nigeria, and Russia (where the toxic mix of sanctions and oil prices led to a recent ratings downgrade). Though the stories behind these crises differ, they all highlight the political and economic dangers of failing to deal with a debt overhang. Together these developments represent a substantial shock to sovereign debt markets that produced attractive returns for investors in recent years. Is the party over? Greece: Old Idea, New Packaging The new Greek government demands debt relief from its official creditors. Its current proposal offers to swap European government claims for a bond with payments linked to Greek gross domestic product (GDP), while the European Central Bank (ECB) would take a perpetual bond with ultra-low interest rates. The result, the government argues, would allow Greece to finance itself with small primary surpluses. The government would also abandon its International Monetary Fund (IMF)-backed program, leaving unanswered how, if at all, creditors would monitor and assess the country’s commitments. Markets initially rallied on the news suggesting a less-rigid negotiating position than initial postelection comments signaled, but have since fallen after learning that the ECB would tighten conditions for Greek banks. Greek bond yields, at 10.3 percent, remain well below earlier crisis levels. GDP-linked payments have a mixed history in debt markets. For private investors, they are often hard to price and it is questionable whether debtor countries receive fair value for what they offer. However, these payments have been a common feature of debt restructurings, including under the 1989 Brady Plan for Latin American debt relief, as the GDP feature provides an upside to participating creditors. Some countries, such as Chile, have used debt-for-equity programs to similar effect. Overall, there have been enough successes to make the theoretical case for an explicit shift from a debt instrument to one linked to capacity to repay. Though debt contracts often end up exhibiting equity-like features (because payments are restructured or deferred when times are bad), there is intuitive appeal and obvious political benefits to a proposal that explicitly does so. In the official context, setting aside concerns about precedent, a central problem for the proposal from the creditors’ perspective will be that—absent a monitored adjustment program—the incentives for slippage would be high. In this case, because the ECB would fund the country indirectly on a low-cost and unconditional basis (though its Emergency Liquidity Assistance program, or ELA) by providing liquidity to banks that in turn buy the government paper, the temptation to rely on the central bank and defer tough decisions will be irresistible. For that reason, some economists have called for official debt relief to be tranched and linked to specific reforms. It is hard to imagine these initial proposals being acceptable to European creditors, and a long negotiation lies ahead. In the meantime, two Greek banks have requested emergency support from the ECB through the Bank of Greece, highlighting the country’s continuing funding needs. The fiscal position deteriorated sharply in the run-up to last month’s elections, and even a small primary surplus will be difficult for the government to reconcile with its campaign promises. It is most likely that, even in an optimistic scenario, Greece will need continuing official support. Government debt, which now exceeds 175 percent of GDP and is mostly owed to the IMF and European governments, will continue to rise following years of crisis lending and a private sector debt restructuring in 2012. I have argued elsewhere that the Greek government can produce a temporary growth surge inside or outside the eurozone, but that the main scenarios for doing so make consensual debt relief harder, not easier, to achieve. Without long-term growth, even substantial debt relief is a temporary palliative. Greece needs more than a fiscal-driven boost to growth to achieve longer-run competitiveness and sustainability; there is no path to normalization that does not involve a significant markdown of Greek debt. For now, Greece and its creditors are so far apart, their perceptions of their negotiating leverage so different, and time so short to reach an agreement, that the risk of failure seems higher than implied by market prices. The substantial losses that would result with either a Greek exit or capital controls would have broad repercussions, even though Europe is better prepared to deal with those contingencies now than it was from 2010­ to 2012. These include large losses to holders of Greek debt, which are mostly European banks, and substantial moves in asset prices as investors adjust their views about the risks of investing in the eurozone periphery. Moreover, any growth in Greece could embolden anti-austerity parties elsewhere in Europe. In a year, the debate may be over whether the rest of the periphery should copy Greece, not the other way around. Ukraine: A Reprofiling By Any Other Name Last week brought news that Ukraine will “consult” with its creditors “on how we can work together to improve the medium term debt sustainability of the country,” in conjunction with negotiations to fix its failing IMF program. In plain speak, this means Ukraine will restructure its debt as a condition for continued IMF lending. Though debt has risen sharply in recent months, Ukraine’s difficulty meeting near-term financing needs, rather than a clear calculation of debt unsustainability, that is driving the decision to restructure in the spring. The IMF has identified additional funding needs of $15 billion, and bilateral official contributions from the United States and Europe have fallen well short of that, leaving the Fund in the tough position of writing progressively larger checks, or seeking a “bail in” of private creditors. The tremendous uncertainty stemming from the Russian conflict, as well as limited adjustment progress so far, would seem to call for a wait-and-see attitude, even though it is likely that deep restructuring will be necessary. It seems logical to support the financing for the program, keep the creditors in by pushing back all maturities a few years, and decide on whether and by how much to ultimately reduce debt once the uncertainty is resolved. In IMF speak, that is “reprofiling.” Unfortunately, the willingness of the IMF to provide clarity on its approach seems to be limited by a broader debate over reprofiling. In a number of papers over the past two years, the Fund has pushed for strengthened rules making reprofiling a condition for IMF lending in certain cases where the Fund is providing exceptionally large loans and where debt sustainability is not assured. (Is it ever?) Those proposals have proven contentious because they seek to tie the hands of the Fund’s shareholders and could significantly affect market dynamics. Moreover, an agreement with the major shareholders (notably the United States) is far from assured. The Fund cannot prejudge those negotiations, but as a result it seems unwilling to associate Ukraine with the initiative. That has created a great deal of uncertainty about what the Fund would like to see done. Some of the terms likely to come out of a negotiation between Ukraine and its creditors would differ from the reprofiling proposal. For example, I would expect all external debt maturities to be pushed back to maintain intercreditor equity, though the Fund’s proposal anticipates that reprofiling would generally be limited to the three years of Fund arrangements under negotiation. The alternative would be a deeper restructuring to fix Ukrainian debt once and for all. That approach would deal with the overhang, but at the risk of getting it wrong and having to do it again in a few years. It would be a shame if the decision is made to restructure when a reprofiling better fits Ukraine’s needs. These counties are not alone: Oil exporting countries such as Venezuela and Nigeria are also struggling with debt burdens that they cannot handle with oil prices at current levels. It is often the case that difficult restructurings catalyze the policy community to strenthen the architecture for resolving debt crises. This may be such a time. Looking Ahead: Kahn's take on the news on the horizon The sanctions game continues Further sanctions appear likely following intensified military attacks from Russian-backed separatists in southeastern Ukraine. So far, sanctions have not excluded Russia from the payments system, but that could change. Eurozone easing may not be enough The ECB’s announcement of quantitative easing was well received by markets, but significant skepticism exists about whether it will be sufficient to restore above-trend growth. Time for Abe to release his third arrow Japan needs to boost its structural reform effort (the third arrow of Abenomics, along with monetary and fiscal policies), but will the government take the tough structural measures it requires?

Bottom Line: Recognizing that the recent debt restructuring was insufficient to restore Greece's creditworthiness, the IMF will likely toughen conditions for lending to countries with unsustainable debt levels What is in the espresso at the International Monetary Fund (IMF)? In well-publicized discussions of debt restructuring and the Greek crisis, the IMF has shown refreshing candor and clear-headed analysis of what has gone wrong. The Fund readily admits that mistakes were made, to which European policymakers have taken offense. Beyond the headlines, the reports provide hints of how the Fund's involvement, and the broader strategy for resolving debt crises, is likely to evolve in coming years. Mostly, the change is for the better. Too Little, Too Late The IMF's core insight is that recent debt restructurings have come too late and have often been insufficient to restore creditworthiness. The answer in some cases is to pull the plug earlier. For example, the Fund acknowledges that Greece deserved support in 2010 despite severe doubts about creditworthiness (doubts that could have been more properly acknowledged at the time), and that a restructuring should have taken place in early 2011 when it became clear the bailout program was failing. The 200-billion-euro sovereign debt restructuring did not occur until February 2012. Where solvency is uncertain but risks are high, the alternative would be to extend maturities and keep creditors at the table until success or failure becomes clear. In some cases, that can include "moral suasion" (e.g., Korea in 1997); in other cases it can involve more formal agreements to maintain exposure (e.g., the Vienna Agreement for coordinating commercial bank exposure to eastern Europe in 2009). The Fund also sees merit in a restructuring that extends maturities on similar terms so official funds don't go to financing the exit of private creditors—a "light dusting" restructuring in the words of law professors Lee Buchehit and Mitu Gulati. Time will tell whether a subsequent restructuring will be needed to achieve debt sustainability. Last week's €1 billion bond exchange by Cyprus showed this approach in action. The Power of Yes A second set of arguments questions whether fear of contagion, the time needed to build firewalls, or the desire to put off hard choices is delaying smart policies. In his play about the financial crisis, The Power of Yes, David Hare commented on the inherent allure of deal-making in the private sector and the optimism it engenders that all can go well. So, too, for international rescue efforts. It will nearly always be the case that countries on the precipice of default will see the temptations of deal-making as a route out of their problems and plead for a chance to make good. Faced with the possibility of a successful deal, it is difficult for the official community to say to countries "no, we don't believe you can make it," especially when faced with severe risks of contagion. Thus, there will always be a built-in bias toward giving the country another chance. Similarly, countries will put off hared choices when "friends with money" are willing to finance the delay. This scenario is as true in Egypt, where aid from countries in the region is allowing the government to delay agreement with the Fund on a sustainable energy and food-subsidy program, as it is in Europe. Particularly at a time of systemic crisis, when creditor countries may flinch at taking tough stands for fear of contagion, the risk of delay rises. A Problem Worth Fixing? The Fund's argument that the recent experience with debt restructuring reflects a problem with markets that requires a policy change is problematic. Absent a few well-publicized cases (e.g., Angola and Argentina), holdouts and litigation have not been an important deterrent to getting deals done or countries achieving their macroeconomic objectives. The Fund fears the upcoming decision in Argentina's legal battle in New York courts will change that. But it is hard to argue the current approach of market-based debt restructuring is failing. In fact, government sensitivities about holdouts, especially in Europe, are more likely behind the current drive to punish "vultures." "Its Stated Political Preference" The Fund's admission of fault about its involvement in Greece further stirred the pot in Europe. Its report blames excessive optimism about economic growth for contributing to other misjudgments about fiscal policy, financial sector stress, the capability of the government to implement structural reforms, and debt sustainability. The analysis brought a sharp reaction from Olli Rehn, the European Union's economic chief, who complained, "I don't think it's fair and just for the IMF to wash its hands and throw the dirty water on the Europeans." The report highlights a number of successes with the program, including strong fiscal consolidation and pension reform. And, in classic Fund speak, it notes that "Greece remained in the euro area, which was its stated political preference." What it does not do is make a convincing case that Greece benefits from remaining there. It is surprising that Greece has not yet left the eurozone. The country has endured through a profound economic depression. Gross domestic product fell by 22 percent between 2008 and 2012, unemployment increased to about 27 percent in the same period, and prospects for growth remain distant. The program remains on track for now, but a financial gap of around 4 percent of GDP remains to be filled, and, even the Fund admits, more debt relief will be needed to restore a viable debt path toward the Fund's target of 110 percent of GDP in 2022. Even if this is achieved, something on the order of 60 percent is more reasonable for Greece. Ultimately, however, Greece will likely decide to leave the eurozone, and the subsequent depreciation and financial distress, though painful at the time, will set the basis for recovery. Public Debt-to-GDP and Timeline of Debt Restructuring and Fund Arrangements Source: IMF The Way Forward All this suggests that the Fund will act differently in future crises. A bitter divorce, however, is unlikely: the Fund will remain engaged in Europe and will still provide financing to countries in need. But there will be changes. The Fund will likely support strengthening binding rules for dissident creditors (collective action), and is likely to toughen up the conditions for lending when debt sustainability is in question. This is already happening in the IMF's threat to cut lending to Greece if there is not a fix for a shortfall in the financing of its program, which has resulted from European central banks being unwilling to take previously expected haircuts on their debt holdings. And they are likely to modify or eliminate their rule (put in place for Greece) allowing extra IMF funding when contagion is a concern. All these are important steps toward a better framework that reflects lessons learned from past mistakes. Looking Ahead: Kahn's take on the news on the horizon Greek Aid Cutoff? The Greek program has a financing gap in 2014. Will the Fund approve a disbursement in July? Perhaps, but a showdown over shortfalls in official aid is coming soon. China's Shadow Banking Sector Allowing shadow banks to fail could be a sign of needed discipline, or the canary in the coal mine for bigger problems. The Fed's Unemployment Threshold Expect a debate to heat up on lowering the threshold for exit from 6.5 to 6 percent. Does it matter?