Thursday, March 15, 2012

Greece Debt Deal - Only A Pause Before The Avalanche

This article of mine was published in Hindu Business Line on Feb 22, 2012 Link

The Bailout package announced by Euro Finance ministers for Greece is more of the same can kicking exercise which is unlikely to last.

First let me point out some of the key ingredients of the deal:
-          -  Greece government would be given 130 billion euros to pay down its creditors and also for its re-financing needs
-     -  The plan is to reduce the Greek debt to GDP ratio from 160 percent to 120 percent by having a dual approach of austerity and reducing the NPV of the Greek debt by making the creditors take a voluntary haircut of around 53.5% on their debt holdings by reducing the coupon payments on the debt and extending the maturity of existing debt

-         -  The ECB has swapped the Greek bonds worth about 50 billion euros that it was holding in its books with another set of Greek bonds that won't be subject to any future forced restructuring like those held by private bondholders.

Now let me elucidate the fallacy of each of the above three salient points of the deal. First let’s see how these 130 billion euros are expected to be distributed among various parties.

As can be seen from the graph only 19 cents for every dollar goes into spending inside Greece, the rest gets paid to the creditors. So almost 80 percent of the European taxpayers money is being channeled to the banks and financial institutions.

Secondly the plan to reduce the Greek debt burden from 160 percent of GDP to 120 percent of GDP without almost wiping out the debt held with the private sector banks/creditors would prove to be a mirage. According to the studies done by Kenneth Rogoff and Carmen Reinhart no country save for Swaziland has ever came out of the debt trap without hard restructuring of its debt or currency devaluation. For Greece being part of the Euro, currency devaluation is not really an option. Without the option of massive currency devaluation or such a restructuring a simple cursory understanding of economics would reveal the near improbability of bringing down the Greek debt load.

From basic  economics we know that a change in  change in private sector savings is equal to the change in the government spending net of change in the current account balance i.e. ∆S = ∆G + ∆NX. Greece is currently running a current account deficit of 6.7% of GDP and assuming it remains constant, as being part of the Euro Greece has relatively open borders for free flow of goods and labour within the Euro Zone thus making it difficult to impose huge tariffs and duties on imports. Now the government’s primary deficit is planned to be reduced from 2 percent of GDP (total deficit is 9.5 percent) in 2011 to a surplus of 4.5 percent.

This can only happen with a sharp reduction in Greek Savings or if the Greek citizens can come in and take more debt. With The private sector in Greece equally levered like the government and at the banking sector facing severe capital crunch , it would be difficult for the Greeks to take in more debt as a result the proposed massive public austerity would lead to a sharp reduction in the savings rate. This would cascade into the banks calling back the loans already given to corporates and public thus further lowering the growth rates and in turn the government tax revenues.

The chart below describes this growth conundrum:

As can be seen from the diagram that this austerity drive if not accompanied by massive debt restructuring/forgiveness or currency depreciation would lead Greece into a vicious circle of deflationary depression spiral.

Lastly the swap of bonds that the ECB has done is going to set a dangerous future precedence as now the sovereign bonds held at ECB would rank senior in any future restructuring and so the next time ECB buys the sovereign debt of Spain and Italy after this brief post LTRO hiatus it could lead to further turmoil among private bond holders.

The current debt deal would only ensure that the Greek depression that has continued for the last 5 years!!! is going to prolong much longer and so the only way out for Greece in getting back to a sustainable growth trajectory is to either restructure its debt even more wherein the private bondholders may end up getting completely wiped out (the ECB holds about 40% of Greek debt which as mentioned earlier is hands-off to restructuring) or break out of the Euro zone and re-ignite its industries with a competitively devalued currency.

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