Brinkmanship in Brussels, Sturm and Drachma for Greece and Europe

Just as it did when Congress recently extended the payroll tax cut, brinkmanship has produced an early morning deal in Europe to extend a new lifeline to Greece and clear the way for the biggest sovereign bond restructuring in history. Both pieces of the agreement—the privately held Greek debt write-down of more than €100 billion and the terms of the new bailout extension—have produced widespread doubts in markets and among many analysts. Accordingly, a more detailed look at both is worthwhile, before considering how this package fits into the ongoing brinkmanship between the euro area and the International Monetary Fund (IMF) and the general focus on austerity in the euro area.

Part 1: The Greek PSI Deal

The agreement on the privately held debt write-down—known as Private Sector Involvement, or PSI—is no ordinary bond swap, but instead a remarkably complex transaction of unprecedented scale. The ultimate haircut accepted by the private creditors from the Institute for International Finance (IIF) went up to 53.5 percent of the principal bond value. Factoring in estimated average reduced coupon payments of new bonds of just 2.63 percent in the first eight years and 3.65 percent of the full 30-year period1, the ultimate net present value (NPV) loss for private creditors looks likely to approach 75 to 80 percent.

The new Greek bonds will be governed by English law, which means that the Greek government will not in the future be able to change the regulation of them. They will also be explicitly treated equally (pari passu) with new official sector loans from the European Financial Stability Facility (EFSF) as part of a co-financing assistance package to Greece. These sweeteners notwithstanding, it remains the case that private creditors face dramatic financial losses as a result of this bond swap.

An important technical aspect of this proposed swap is the proposed issuance of new securities linked to the future GDP of Greece. Investors could this see an increase in bond payments if future Greek growth exceeds currently anticipated levels. This type of bond was used in Argentina after its default and has provided investors with good returns as the Argentinean economy rebounded. The critical question remains what future Greek GDP growth will be. If current GDP growth projections are very low, then there is a reasonably certain future gain for private creditors, although such payouts are capped at “an amount of up to 1 percent of their notional amount” beginning in 2015, according to the Greek Finance Ministry. Figure 1 shows the projected Greek real GDP growth rates (from 2011–20) in the baseline scenario in the most recent IMF Debt Sustainability Analysis (DSA).

Figure 1

Many commentators are likely to dismiss the probability of Greece exiting its recession in 2013 or achieving a 2.3 percent growth rate as early as 2014. As we shall see below, such fears are likely well founded. But in a “baseline scenario” where another Greek default is not assumed, one must heed what my late great colleague and forecaster extraordinaire Mike Mussa called the Zarnowitz Rule: “Deep recessions are typically followed by steep recoveries.” [pdf]

According to the IMF estimates, Greece will suffer a cumulative decline in real GDP of about 16 percent from 2009–12, taking the country to near Latvian recession levels. By any definition, that is a “deep recession.” According to the Zarnowitz Rule—named after Victor Zarnowitz, a University of Chicago economics professor who studied business cycles—the projected Greek GDP growth rates after 2013 are extremely conservative, assuming that Greece implements its new IMF reform program. The prospect of Greece not experiencing any noticeable cyclical rebound looks highly implausible in my opinion. The question can be asked: why has the IMF assumed such low future growth rates in its relatively benign baseline scenario?

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