Pain, and very little gain, in the eurozone

Lowy Interpreter

With almost all private-sector bond-holders agreeing to a restructuring deal and the hold-outs gathered in compulsorily, another stage in the Greek saga has passed. But this is just a momentary pause in an unfinished journey to an uncertain destination, with a lot more pain for the Greeks and their euro partners ahead.

Once again the private sector has managed to cut itself a pretty good deal, considering it should have lost all the money foolishly lent to Greece in the days when financial markets saw almost no difference between German debt and Greek debt.

The bond-holders will receive new Greek bonds with face value around half that of the old bonds, and the new bonds have longer maturity and lower interest. Bond-holders are also getting a near-cash 'sweetener' valued at €30 billion. Taken together, it's estimated that the bond-holders are losing around three-quarters of the original value of the old bonds.

Still, they did well compared with the alternative: without the official rescue package from the other euro members, the European Central Bank and the IMF, Greece's creditors would have received nothing. The delay since Greece's de facto insolvency in early 2010 has allowed those with maturing debt to get repaid in full and others to have their debt serviced, neither of which would have happened without the May 2010 rescue. Other bond-holders used the time to unload their holdings onto the ECB (although, of course, at market price). A second official rescue package (originally announced in July 2011) of €130 billion will, finally, be made available.

The rescue money is what makes the current restructuring possible. It also funded a curious action: €25 billion of the rescue money will be used to pay off creditors of Greek banks. Like the bond-holders of the Irish banks in 2008, these creditors are getting off scot-free, fully repaid. Perhaps, as in the Irish case, one motivation might have been that the bond-holders are largely other European banks, whose balance sheet woes will be relieved by this generosity.

This is not, of course, the end of the story. It leaves Greece with a debt-to-GDP ratio of 140 per cent. If all goes according to plan, this ratio would fall to 120 per cent by 2020. Barring a miracle, however, this forecast will not come to pass. Such ratios are rarely improved by the sort of grinding austerity Greece is now undergoing. The ratios come down only if the economy grows or there is enough inflation to erode the debt. There seems little chance of Greek growth any time soon (unemployment is 18 per cent, GDP fell 7 per cent over the past year, and Greece will remain internationally uncompetitive as long as it remains part of the euro area). There is even less chance still of the euro inflating while the Germans are in charge.

The IMF is planning to give Greece more assistance as part of this package (Australia has a small voice here, as a bit of that money is ours). With very little room now left to get the private sector to share the costs of the inevitable further restructurings, let's hope the IMF loan has unambiguous priority over all other debts, most of which are now owed to European governments and the ECB.

The Europeans got into this mess by incompetent policy-making and they have the capacity to bail Greece out. There is little realistic prospect of the rescue money loaned to Greece being paid back in full. But there is no reason why the IMF should bear any of these prospective losses. The ECB is playing a tough hand in resisting any losses on its huge portfolio of Greek debt: the IMF should be tougher still.

It's an ill wind that blows nobody any good. Some (not many, as it turns out) of the Greek bond-holders took out default insurance in the form of credit default swaps (CDSs). For months there has been anxious speculation on whether the insurers would actually pay out, depending on seemingly-arcane technical grounds. This debate has reminded nave enthusiasts of the CDS market that insurers always look to the small print for ways to avoid paying out when an insured event seems to have occurred. This won't do much to check the spectacular growth of the CDS market, but it might remind people that, although you may think you can manage risk, you can rarely get rid of it.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.