Glossing over a Greek debt tragedy

FT.com

The latest deal on Greek debt, in which the fear of imminent catastrophe has driven compromises on all sides, should remove Greek risk from the market agenda at least until the German election next September. While it does not by any means represent a full resolution of the crisis, it does offer the outline of an eventual, larger deal, based on official debt forgiveness, which could keep Greece permanently inside the eurozone.

The deal involves three key ingredients. First, the Greek government has passed a further series of austerity measures which compensate for the slippage in budget targets since the landmark debt restructuring of March 2012. This slippage has occurred largely because real and nominal GDP have fallen below expectations.

Budget tightening has caused negative GDP growth, which in turn has worsened the budget deficit. Importantly, there is little sign that the economy is escaping the austerity trap.

Second, and in recognition of the latest budget package, the eurozone has slightly relaxed the path required for budget consolidation in the immediate future. In February, Greece agreed to achieve a primary budget surplus of 4.5 per cent of GDP by 2014. Now, it says it will reach that objective in 2016. Greece has therefore been allowed two years of extra grace, in common with the extensions recently agreed with other indebted countries in the eurozone.

The €16 billion required to finance that extra borrowing up to 2016 will now be funded by official lenders. Even so, the further tightening in the structural budget stance required under the new deal is extremely daunting. From 2009 to 2012, Greece has tightened its primary budget balance by a remarkable 9 per cent of GDP. Under the new deal, it will have to tighten by a further 6 per cent of GDP in the next four years.

Third, the eurozone has embarked on the long and arduous process of official debt forgiveness, though they have avoided outright cancellation of nominal outstanding debt. The most important (and time honoured) way in which this will be accomplished is through the acceptance of zero or extremely low interest rates on the debt, and the extension of maturity.

In addition, the European Central Bank and national central banks will repatriate to Greece the "profits” on their holdings of Greek government bonds. And the European Financial Stability Facility is effectively making money available to Greece on favourable terms to buy back outstanding debt at a rumoured price of 35 per cent of face value, a little higher than the price at which the debt has been trading in recent days.

As a result of these various elements of disguised forgiveness of official debt, the projected debt/GDP ratio will fall from around 175 per cent in 2016 to less than 110 per cent by 2022. This projection still depends on the optimistic assumptions that the primary budget surplus can be held indefinitely at 4.5 per cent of GDP, while nominal GDP growth rebounds to more than 4 per cent per annum. But for the moment it is enough for the IMF to be able to declare that the path for debt is sustainable.

The key question is whether all this really solves anything. From the point of view of the funders in the rest of the eurozone, it is likely to remove the risk of a possible Greek exit from the single currency at least for the whole of 2013, and it does this without forcing them to admit to their electorates that Greek debt is being forgiven.

For the ECB, the repatriation of "profits” to Greece does not breach the red line of direct financing of budget imbalances. For the IMF, it preserves the illusion of long-term debt sustainability which allows it to release funds. And, finally, for Greece, it provides significant debt forgiveness and heavily subsidised interest payments which allow it time to introduce further structural reforms while remaining within the euro.

What is not solved, however, is the recessionary condition in which the Greek economy remains trapped. This is not just a consequence of the continued budgetary tightening but also of the further reduction in real wages needed to make Greece competitive, and of the absence of a solvent banking sector which is willing and able to lend. The great uncertainty, therefore, is whether the Greek electorate will remain willing to stay with the programme while the unemployment rate rises towards 30 per cent.

The next episode in this unhappy saga will probably come after the German elections. That is when a more radical reduction in official debt might become feasible, in exchange for still further structural reforms in the labour and product markets in Greece. A long-term deal of this sort is still necessary if Greece is to remain permanently inside the euro.

Gavyn Davies is chairman of Fulcrum Asset Management and writes a regular blog on macroeconomics at FT.com

Copyright the Financial Times 2012.