Greek Debt Restructuring – A Political Decision
The question of if, when and how a Greek debt restructuring could take place is a complicated matter. Our projections show that it is still possible for Greece to regain fiscal sustainability and avoid debt restructuring, but it has become a very demanding task and will require more sacrifices than what we have seen so far. It is not clear whether Greece is willing to go through with this.

When all is said and done it is a political decision. To complicate things further Greece is not on its own when it comes to taking this crucial decision. The decision of “if, when and how” involves not only the Greek government, but also EU authorities, ECB, IMF and not least the Germans, who so far have invested substantial political prestige in saving the single currency project. The public opposition in the core countries against lending more tax money to peripheral countries is increasing – as recently reflected in the general election in Finland and state elections in Germany. So the “simple” solution – of sending more money – may eventually come to an end.

In our view, the most likely scenario is a “mild” restructuring involving an extension of maturities, which does not trigger losses on banking books and possibly a reduction of interest rates. Prior to this Greece might receive a new loan package from the EU and the IMF.

The new loan package may be announced soon due to increased market pressure and will in any case have to be announced well before Greece has emptied the first EUR110bn rescue package, which happens in 2012. A loan package of about EUR60bn could delay the need for Greece to undertake a maturity extension or return to the market from 2012 to 2014.

A “severe” restructuring involving significant haircuts on sovereign debt cannot be fully ruled out. But it would be very damaging to the Greek banking system and result in substantial losses for German and French banks as well. Preventing contagion to other periphery countries and the whole euro area banking system would be difficult. Money markets could quickly dry up as they did after the Lehman collapse. We believe European politicians would go a long way to avoid a replay of that event.

At an informal meeting held in Brussels on Friday 6 May European leaders discussed how to tackle the Greek debt crisis. According to leaks from the meeting an extension of maturities was on the table (or re-profiling as politicians prefer to call it). However, the ECB, the Commission and France appear to be against a maturity extension as they are concerned that this could trigger contagion to other peripherals. Even though agreement on a restructuring couldn’t be reached, the genie is now out of the bottle.

Chart 1: Two Year Yield on Greek Sovereign Debt Hovering Around 25%

Chart 2: Debt Projection – Fiscal Sustainability is Still a Possibility…

Since, speculation about a new EU and IMF facility of EUR60bn has circulated the markets. It is possible that a first promise of an extra package could be given soon.

In the following we sketch three different scenarios for Greece. In the first scenario we look at what it takes to avoid a debt restructuring. Then we assess the damaging effects of the worst case scenario with a substantial haircut. Finally, we look at the “mild restructuring” scenario, which in our view is the most likely.

Scenario 1: Greek Debt Restructuring is Avoided 
To bring the government debt back on a sustainable path and avoid a debt restructuring, Greece would need to succeed on three accounts:

1. Substantial additional fiscal tightening in the coming years.
2. A quick return to positive nominal GDP growth.
3. Funding at reasonable rates.

Based on optimistic assumptions for these key variables our debt projections suggest that the rise of Greek debt can be stopped at around 160% of GDP and then reversed to a slowly decreasing trend. As it seems highly unlikely that Greece would be able to get funding from the market at reasonable rates (around 5%) any time soon this scenario would require an increase in the EU/IMF facilities. In the medium term, access to market funding at reasonable rates is a precondition for avoiding debt restructuring.

Chart 3: …But it Requires Substantial Fiscal Tightening

Chart 4: Debt and Deficit in 2010

In the first alternative projection we assume that Greece fails to bring the primary budget surplus all the way up to 4% of GDP and “only” tightens until they get a primary budget surplus of 2% of GDP. This would still be a tremendous effort, but it would not be enough to stop the debt from rising.

In the second alternative projection, Greece returns to funding in the market, but at 10% interest rates instead of 5%. The average interest rate on the debt slowly increases and this puts debt developments on an unsustainable path.

In the third alternative projection, Greece returns to positive nominal growth, but only 2% instead of the 3.5% as assumed in the main projection. Again debt developments become unsustainable.

Massive asset sales may help Greece to avoid debt restructuring. Greece has promised to sell public assets worth EUR50bn over the next five years, which will lower the government debt by as much as 22% of GDP. Privatising and selling assets for such a large amount can be a lengthy and complicated process and we would not be surprised to see that it drags out. Nevertheless, Germany has indicated that more asset sales could be a precondition for increasing aid facilities. Bini Smaghi (ECB executive board member) has recently argued that: “The public wealth that could be privatised is over 100% of GDP”.

If debt restructuring is avoided financial markets could see a rescue of Greece as a signal that sovereign debt restructuring in the euro area will be avoided at any price. As a result sovereign spreads may eventually tighten and not reflect market fundamentals. The absence of market punishment could once again lead to “moral hazard” for indebted countries.

Chart 5: Greek GDP Growth Still in Negative Territory

Chart 6: Greek Budget Gap is Narrowing But is Still Large

Scenario 2: A Severe Restructuring – “We Need a Haircut!”
The recent increases in sovereign spreads on Greek debt, albeit in a very thin market, reflect concerns that a restructuring involving haircuts is unavoidable and could be around the corner. As our debt projections made clear, very little has to go wrong before debt levels plunge to the depths. Lagging political effects will be internally and externally triggered by public sentiment against further tightening and additional loans respectively could be the beginning of the end.

The direct effect of a haircut will be immense losses, not only for Greek banks, which have about EUR63bn of Greek government bonds, but also for German and French banks, which hold Greek government debt for about EUR26bn and EUR20bn respectively. Other major “investors” are the EU and IMF, which so far have disbursed loans totalling EUR38bn and EUR14.5bn respectively and the ECB, which has bought Greek government bonds for an estimated EUR45bn. Total outstanding debt is about EUR330bn, so a 40% haircut would result in total losses of about EUR130bn.

A key element here is the accounting difference between assets on the trading book and the banking book. Sovereign debt on the banks’ trading books is marked to market, while holdings on the banking book are held at nominal value. At least 80% of Greek sovereign debt is held on banking books. The potential losses on most bonds have thus not been taken yet even though the bonds trade at heavily discounted values. Maturity lengthening does not trigger similar losses while interest rate reductions force banks to book losses to take account of the reduction in net present value.

A sudden announcement of a haircut on Greek bonds is likely to result in contagion to other periphery countries as concerns about a haircut in, for example, Ireland and Portugal would increase sharply. Uncertainty about which counterparties may face large losses could trigger a freeze in interbank lending that could resemble what happened following the collapse of Lehman Brothers in autumn 2008. A sharp credit tightening would follow, which could dampen EU growth prospects significantly. In addition, Greek banks are major lenders in Romania and Hungary, so a credit squeeze in these countries should also be expected.

Chart 7: Alternative Debt Projections

A haircut will also trigger CDS (credit default swap) contracts. Luckily the CDS market is not very big relative to the Greek sovereign debt market. According to data from the Depository Trust & Clearing Corporation (DTCC) the gross issuance is US$77.5bn while the net notional (maximum bank exposure) registered by DTCC is just US$5.5bn, or less than 2% of outstanding debt. The exposure could potentially cause problems for some banks, but is not a threat to the system. The CDS exposure is negligible compared with the CDS exposure on subprime loans that fuelled the financial crisis.

We do not believe that the euro area banks are ready to endure the cost a haircut would inflict on their balance sheets. The euro leaders are aware of this and the last thing they want is another freeze in the interbank market. In conclusion we believe that the risk of a haircut any time soon is very small.

Chart 8: Holders of Greek Government Debt

Chart 9: Greek CD S Spreads

If a haircut is announced later on, the timing can turn out to be crucial. In mid-2013 the European Stability Mechanism (ESM) will replace the European Financial Stability Facility (EFSF) and the loans given to periphery countries will change to senior status, similar to IMF funding. The details on this are not spelled out yet. The consequences of having both EU and IMF loans treated with senior status could potentially be devastating for private investors. An increase in the facilities could actually be bad for private investors, since additional EU and IMF funds may reduce private investor recovery rates.

Scenario 3: A “Mild” Debt Restructuring 
The most likely scenario is in our view a restructuring involving an extension of maturities and potentially a reduction of interest rates. Prior to this Greece could be granted an enlargement of the initial EU/IMF facility.

A debt restructuring involving maturity lengthening would not result in nominal losses on banking books. This would substantially reduce the risk of money markets drying up.

An extension of maturities and/or a reduction in interest rates will, if it is not truly voluntary for all investors, trigger CDS contracts. Whether a credit event has taken place is determined by the International Swaps and Derivatives Association (ISDA).

We expect limited contagion to other peripheral countries, as long as they manage successful turnarounds. Ireland and Portugal need to be given time to show that they are not Greece before a restructuring is announced in order to avoid contagion.

More time would also help banks to consolidate balance sheets and thus reduce the systemic risk from some banks’ heavy exposure to Greece and other peripherals countries.

Chart 10: Foreign Banks’ Exposure to Greek Default is Substantial

Chart 11: Foreign Banks’ Exposure to Ireland by Country

In addition the EU and not least some core countries would like to keep reform pressure on Greece for some time. It is likely that they will lose some leverage if/when Greece gets additional help and are allowed to undertake a “mild” restructuring.

We thus see several arguments for not announcing a debt restructuring too early. Nevertheless, this may happen anyway as financial markets are clearly waiting for answers and the debt crisis appears to be worsening day by day as no answers are given.

There are also limits to how long the politicians can wait. Greece has already borrowed EUR52bn from the EUR110bn rescue package and will run out of money in 2012 when EUR26bn will have to be funded in the bond market according to the IMF third review unless alternative solutions are found. German general elections take place in September 2013 and we believe that Angela Merkel would like to see the debt crisis long gone by then.

If the EU/IMF facility has increased by about EUR60bn this would delay the need for Greece to return to the bond market from 2012 to 2014. The debt to GDP ratio would still be very high in 2014 and it would probably still be difficult for Greece to return to the market at reasonable rates, so a new rescue package of this magnitude will probably only delay the need for a restructuring – it will not replace it.

In contrast if a maturity lengthening of, for example, five years is announced soon Greece’s financing needs could be covered by the existing EU/IMF facilities and planned privatisation receipts until 2016. It is much more plausible that Greece’s fiscal situation and growth outlook will have improved sufficiently for it to be able to regain market access by then. If such a “re-profiling” is announced soon additional EU/IMF help may thus not be needed. However, we believe that for now European politicians prefer to put more money on the table rather than forcing a “mild” restructuring.

A major risk is that debt developments may still look unsustainable when a new loan package and/or a maturity lengthening has run its course. If so a haircut becomes unavoidable. As the debt projections in scenario 1 showed, the debt trajectory will remain unsustainable if Greece fails to deliver substantial fiscal tightening for years to come, if growth does not return or if Greece cannot get funding at reasonable rates. These alternative scenarios are fairly plausible. It is thus far too early to rule out that a haircut could take place at a later stage.

Chart 12: Foreign Banks’ Exposure to Portugal by Country

Chart 13: Foreign Banks’ Exposure to Spain by Country

Macro Economic Development and Outlook – A Brief Overview
In May 2010 Greece gave in and received much needed help from the EU and the IMF. After a decade of strong economic growth, partly due to unsustainable fiscal support, Greece entered a slump. GDP shrunk 4.5% in 2010. The IMF (WEO Spring 2011) projects that the economy will contract 3% in 2011 before GDP is expected to turn positive with a projected growth of 1.1% in 2012. The need for fiscal tightening is significant and may delay the recovery. Structural reforms are expected to increase the long-term growth potential.

The Greek government deficit was above 15% in 2009 and was in 2010 at 10.5%. The IMF projects that the deficit will decrease to 7.4% of GDP in 2011 and 6.3% in 2012. Not before 2014 (2.5% of GDP) is Greece expected to crawl under the 3% deficit limit dictated by the Stability and Growth Pact. The Greek Finance Minister recently said that it could take as long as until 2016 to cut its deficit to 3% of GDP.

The IMF estimates that the debt-to-GDP ratio will increase from 142.8% of GDP in 2010 to 152% in 2011 and 158% in 2012. The current account deficit has declined from 14½% of GDP in 2008 to 10½% of GDP in 2010 and is expected by the IMF to shrink to 7% in 2012. The large deficit reflects that the Greek spending level has not been sustainable for years.

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