Bruegel: Greece is insolvent, urgent debt reduction is needed
Ralitsa Kovacheva, 17 February 2011
At their March Summit, the leaders of the euro area countries are expected to come forward with concrete proposals for tackling the debt crisis – on the changes in the euro area rescue fund (EFSF), on the nature and functions of the permanent fund - the European Stability Mechanism, on the Pact for Competitiveness, proposed by France and Germany. On 11th of March the euro area will hold its first separate Summit before the European Council on 24 and 25 March.
To give a comprehensive response to the debt crisis, the European Union should consider two basic facts. The first is that the countries in the periphery of the euro area - Greece, Ireland, Portugal and Spain, must emerge from the vicious circle of high indebtedness, on one hand, and low growth on the other. The second is the relationship between banks and sovereign debt not only in peripheral economies, but also between them and other eurozone countries. Based on these assumptions, the influential Brussels think tank Bruegel published a report criticising the current policy (and rather the lack of it) and analysing possible future actions.
The previous measures, taken by the EU, failed to restore market confidence, analysts say - by February 2011 spreads on 10-year government bonds issued by Greece, Ireland, Portugal and Spain were higher than they were in April 2010, before the emergency measures were implemented. There are three reasons for that: the EU has refused to recognise the possibility of insolvency, it has failed to address in a systematic way the interdependence between banking and debt crisis and the interdependence across countries, and has acted more reactively than pro-actively with partial, inadequate and belated reactions.
The strategy, recommended by Bruegel, consists of three elements:
- Reduction of Greek public debt, arguing that “Greece is the only euro area country which has become insolvent”.
- Restructuring of the banks, where necessary, and simultaneously throughout the euro area, based on rigorous stress tests, involving the IMF.
- Promote growth in peripheral economies, not only through fiscal consolidation and strengthening of competitiveness, but through the mobilisation and better use of EU structural funds.
The authors note, as euinside has repeatedly written, that the roots of today's problems of the peripheral economies lie in the imprudent fiscal and economic policy, especially after joining the euro area: “They have spent and lived beyond their means by accumulating private and/or public debt and running large current account deficits. Nominal wages have also grown significantly more than justified by productivity performance, resulting in prices growing too fast in comparison to the rest of the euro area.”
In Greece, however, the situation differs from the other three countries for two reasons. First, the Greek debt is mainly due to poor management of public finances, while the banking problems have only a secondary role. Second, “with a debt-to-GDP ratio scheduled to reach 150 % in 2011 and to continue rising in subsequent years, the country is clearly on the verge of insolvency”. Unlike Greece, in Ireland and Spain the main cause of the problems with public finances is the accumulation of debt by the private sector and the need to rescue failed banks. Moreover, the debt levels of Spain, Portugal and Ireland, respectively 70, 90 and 110% of GDP are still manageable, unlike the Greek situation.
The analysts use two scenarios for future development of the debt crisis. The optimistic one suggests that interest rates spreads, of the four countries against German Bonds, will fall significantly by 2014 and the economy will start growing. The cautious one assumes that the reduction of spreads will be less, and particularly in Greece, Portugal and Spain, “where the business climate is weak and where we see serious competitiveness problems”, efforts to regain competitiveness will have a negative impact on growth and inflation.
Moreover, both scenarios assume the need of potential additional bank recapitalisation by governments, as this risk is high for Ireland and Spain - in Spain the price could reach 75 billion euro, which does not include the state aid already been paid to banks. For Ireland, the amount is 31.5 billion euro and 10 billion euro for Greece and Portugal each.
The estimates of the analysts suggest that even under the optimistic scenario, to reduce its debt below the limit of 60% within 20 years, Greece will have to maintain a primary surplus (before interest payments) of 8.4 percent of GDP and under the cautious scenario - 14.5 percent. That means between one fifth and one third of tax revenues to be used for interest payments on public debt. In comparison, to reduce its debt below 60% of GDP in the period 2014 to 2034, Ireland will need a permanent primary surplus of 3.7 percent under the optimistic scenario and 6.1 percent under the cautious scenario, which seems much more realistic .
”Over the last 50 years, no country in the OECD (except Norway, thanks to oil surpluses) has ever sustained a primary surplus above 6 per cent of GDP. Even less ambitious targets would require politically unrealistic surpluses.”
The conclusion is that Greece has already become insolvent, so the only solution is reduction of its debt. The analysts recall that until recently this possibility has faced strong opposition in some eurozone countries, mostly because of the impact on banks (mainly French and German) with large investments in peripheral bonds. Hopes were that time would help, on the one hand, Greece to conduct the necessary budgetary consolidation and reform, and on the other, banks in the euro area to restore solvency.
However, there is a visible change in responses on this issue - the restructuring of the Greek debt is no longer facing full denial but rather a middle way is wanted. According to the report of Bruegel, three types of measures are being discussed: lowering of the interest rates of all official EU loans to 3.5 percent per year, an extension of their maturity to 30 years, as well as the purchase by the EFSF of all government bonds currently held by the ECB “and the retrocession of the corresponding haircut to the issuing country”.
According to the analysts, even if applied simultaneously, these measures will reduce the interest burden on Greece, but won’t be enough to make the country solvent again, because it will still need unrealistically high primary budget surplus. So emergency actions are needed now and not as provided by the plans for the European Stability Mechanism- from 2013. “Up to 2012, markets will price in the default option, making it difficult for troubled governments to borrow. From 2013 on, if the stance is indeed maintained, the Greek government will not be able to issue bonds.” Therefore, according to Bruegel, in addition to the measures described, Greece needs a 30 percent haircut to the marketable public debt.
This won’t cause some uncontrollable spillover effect throughout the eurozone, the analysts argue. According to them it will be inevitable some banks to be recapitalised, but even this to be done with public funds, the impact on public finances will remain limited. “Therefore, the fear of domino effect is understandable, but excessive.” As for Ireland, the exposure of banks in the euro area to Irish debt is insignificant, what matters is the exposure to Irish banks, the report reads. Exposure to Portugal is limited and only Spain is really of systematic importance.
Bruegel recommends at their March Council the eurozone leaders to decide to increase the functions of the rescue fund (EFSF), which to start immediately buying debt securities from the ECB. Debt reduction should be achieved through voluntary exchange, not by an overall restructuring, and the burden should not fall only on the private bondholders, analysts recommend. In addition, the interest rates on the loans of Greece and Ireland from the EU and the EFSF must be reduced in line with EU's assistance to Hungary, Latvia and Romania.
To take this step, however, a clear picture of the state of the euro area banks is needed. As the report notes, we have data on the exposure of peripheral banks to peripheral sovereigns and of non-peripheral banks to both peripheral banks and sovereigns. “What is missing however from our mapping is the exposure of peripheral banks to potentially non-performing loans and the resulting risk for banks in the rest of the euro area as well as for sovereigns in both peripheral and non-peripheral countries should banks need to be recapitalized with public funds. This crucial missing link was supposed to have been filled by the European stress test published last July. Unfortunately it was totally discredited by subsequent developments in Irish banks and markets have been concerned ever since that the current and future situation of banks in the euro area may be far worse than currently admitted.”
In the first half of this year, new stress tests will take place, which European officials promise to be more stringent and reliable than previous ones. “Once such tests have been carried out, euro area countries, not only in the periphery but also in the core, must proceed immediately with the restructuring of their banks where necessary, which should imply the recapitalization of viable institutions and the closure of nonviable ones. To this end, EFSF funding should be made available to governments if necessary.”
According to Bruegel, only in Spain the restructuring of banks can have a significant influence on the rest of the euro area. To facilitate the process, analysts advise member states to introduce national mechanisms for bank restructuring in accordance with the proposals in the Pact for Competitiveness. They also note the need for strong European framework for banking supervision and resolution. As euinside has already written, currently there are consultations among member States on the European framework for crisis management in the financial sector, proposed by the European Commission. It is expected the Commission to make a legislative proposal on the matter by the summer.
The great challenge, which the peripheral economies are facing, is that debt reduction “will require a combination of lower living standards and higher production levels, especially in the tradable sector.” That means to implement reforms aimed at increasing employment and productivity. But while the reforms give their results, growth will be hampered by the efforts to pay debts and low growth will make more difficult to reduce debts.
To break this vicious circle, peripheral economies must be supported by the EU through better and focused use of Structural Funds. In the discussions on the next multiannual financial framework for 2014-2020 new ways should be searched to encourage investment as in the four countries concerned, so in other crisis-affected countries, especially in Central and Eastern Europe, the report recommends.
That said we can conclude that, although still not articulated in plaintext and on a European level, the idea of restructuring the Greek debt is no longer a taboo in the EU. Moreover, the necessary conditions for this to happen in the most painless way apparently are being prepared - the changes in the rescue fund for the euro area, the Pact for Competitiveness, the stress testing, the European framework for crisis management in the financial sector. From this perspective and given the need some uncomfortable truths finally to be addressed openly, it seems a realistic possibility debts to be counted in the autumn (after the proverb that sheep are being counted in the autumn).