The Threats to Greece’s Debt Deal

05.01.2012 15:19

WSJ: The process of imposing losses to private-sector holders of Greek debt–known as private-sector involvement or PSI–has dogged policy-makers for months. If the Greek finance minister is to be taken at his word, the first large-scale restructuring of sovereign debt of the euro area is nigh.

But the real question is not whether Greece will reach a voluntary agreement with its creditors, but by how much the deal will ease its debt burden. What follows is an analysis of  creditor groups that may threaten the process and what a shortfall in the hoped-for debt reduction would mean.

The Oct. 27 agreement for the restructuring envisages the debt stock of €206 billion in private-sector hands would be halved to €103 billion. In order to reach this target, all of Greece’s private-sector creditors also have to agree to the terms of the restructuring voluntarily.

In the debt-sustainability analysis conducted by the International Monetary Fund and others in October, Greece could need up to €440 billion though 2020. Euro-area countries and the Fund itself couldn’t or wouldn’t provide all this money. Private creditors holding Greek debt would therefore have to take losses to help return Greek debt to a sustainable level. The figures on how to do this can be found in a critical paragraph, on page 7 of the report, put online here by the Financial Times:

“Deeper PSI, which is now being contemplated, also has a vital role in establishing the sustainability of Greece’s debt. To assess the potential magnitude of improvements in the debt trajectory, and potential implications for official financing, illustrative scenarios can be considered using discount bonds with an assumed yield of 6 percent and no collateral. The results show that debt can be brought to just above 120 percent of GDP by end-2020 if 50 percent discounts are applied. Given still-delayed market access, large scale additional official financing requirements would remain, estimated at some €114 billion (under the market access assumptions used). To get the debt down further would require a larger private sector contribution (for instance, to reduce debt below 110 percent of GDP by 2020 would require a face value reduction of at least 60 percent and/or more concessional official sector financing terms). Additional official financing requirements could be reduced to an estimated €109 billion in this instance. Of course, it must be noted that the estimated costs to the official sector exclude any contagion-related costs. ”

But full participation in the restructuring, which is meant to be voluntary, seems chimerical, as  suggested by this academic paper that we discussed last week, by Mitu Gulati of Duke University and Jeromin Zettelmeyer of the European Bank for Reconstruction and Development.

According to the Gulati-Zettelmeyer paper there are several categories of creditors who will be tempted to hold out and not participate in the voluntary restructuring, chipping away at the €103-billion debt-reduction target. We add some of our own.

Holders of Greek debt maturing in 2012 (some €36 billion) will have no incentive to participate in the exchange of bonds currently negotiated because they would receive bonds maturing in 20-30 years in their stead and singing up for that would likely be deemed, well, silly
Gulati and Zettelmeyer cite JPMorgan research that finds that some €120 billion of Greek debt is held by big institutional investors, such as banks and others who care about their reputations and would probably participate in the PSI deal, while €80 billion is held by hedge funds, sovereign-wealth funds and other types of funds. The chances of holdouts are high among the latter
Creditors who have bought insurance, through credit default swaps, to hedge their holdings of Greek debt also have reasons to pass on the deal. An involuntary restructuring would trigger their CDS contracts and guarantee them full repayment on their holdings
Let’s not ignore the so-called “vulture funds” that specialize in pre-restructuring purchases of distressed debt and free-ride to benefit from the restructuring process
(The €206 billion excludes two big categories of holdings: the €54 billion held by the European Central Bank, bought at an estimated 80 cents to the euro as part of its Securities Markets Program, which are unlikely to suffer a hit, and the €23 billion held by Greek pension funds that seem likely to.)

Assuming that holders of the €36 billion maturing in 2012 won’t agree to restructuring brings down the €103-billion reduction goal to €85 billion, also providing perfect participation among holders of the other bonds, as we illustrate in our worry-list above, is anything but certain.

Small wonder colleagues at Dow Jones Newswires reported a few days ago that the IMF has warned Greece that the 50% haircut might not be enough.

The shortfall in Greece’s financing created by a failure to reach the €103-billion debt-reduction goal and deteriorating economic conditions would have to be covered by official lenders: the IMF and the euro-zone governments. The alternative would be a harder debt restructuring to force the private sector to take much higher losses, allowing Greece to reach sustainable debt levels without adding funding burdens to official creditors.

By Matina Stevis