The face value of Greece's sovereign debt is now roughly 150% of its GDP and on course to reach 161% by 2013. This is excessive by anyone’s standards. As the IMF and ECB have insisted, Greece must endure austerity to achieve a primary surplus in its fiscal accounts and thereby slowly reduce the debt-GDP ratio. But even with tough fiscal policy, the stock of debt will long remain much too high for Greece to sell new bonds in the private markets. Additional measures are needed to slash the face value of sovereign debt.
Last week, one credit rating agency rejected the Eurozone’s preferred solution to the excessive debt stock – that is, sizeable “voluntary” private-sector involvement, meaning a long rollover at low interest rates of debt held by Eurozone private banks. Moody’s called this approach “selective default” – a label that would make it almost impossible for Greece to raise new private money for several years.
Debt buybacks are the only option
private-sector involvement off the table, European officials must come up with a new strategy for reducing the excessive debt stock. Other commentators have already lectured EU policymakers on the need to buy back bonds as part of the solution to the peripheral debt crisis (see Gros and Mayer 2011 on this site). And given the huge discount at which Greek bonds now trade in secondary debt markets, debt buybacks are clearly the obvious policy. The face value of debt relative to GDP would drop, calming financial markets. While austerity gradually cures the underlying fiscal disease, Greece could finance its public deficits by placing bonds in the private market at reasonable interest rates.
The critical question is who could carry out debt buybacks? Recent discussions suggest that bond buybacks are again on the table as an option for enhancing the flexibility of the EFSF.1 But Article 125 of the European Treaty strictly limits the ability of the European Union and its member states to assume the financial commitments of weaker members. The language is worth quoting:
125. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
EU leaders have invoked this article to deny the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) the power to purchase deeply discounted debt in the secondary markets. Meanwhile, the European Central Bank (ECB) has essentially halted its Securities Markets Program, after spending almost €75 billion to stabilise the financial markets for Greek, Irish, and Portuguese public debt. In other words, the central European financial authorities are now unable to carry out debt buybacks.
Even if their reading of Article 125 is overly strict (as we explain later), it seems apt that EU leaders are resisting measures to socialise the extravagance of a few countries across the entire currency area. Eurozone taxpayers by and large had no say over the decades of economic mismanagement that have now bankrupted Greece, nor over the incompetent banking regulation that facilitated reckless lending to Greece by German, French, and other private banks. Greeks voters need to mend their ways, and it is entirely appropriate that, in return for lavish international financial assistance, they now face years of harsh austerity. Yet that reality still leaves European officials staring at the problem of the excessive Greek debt stock.
Apart from the text of Article 125, for burden-sharing reasons neither the EFSF/ESM nor the ECB is the appropriate agent to carry out further Greek debt buybacks. Any losses suffered by the ECB and/or EFSF/ESM would be distributed across all members according to the ECB’s paid-up capital structure, whereby Germany accounts for 27%, France for about 20%, Italy 18%, Spain 12%, and so on.
The Eurozone private bank exposure to Greece meanwhile is concentrated in German and French banks to a far larger extent than their national ownership of the ECB. The latest end-2010 BIS data shows that French and German banks hold 26% and 38% of the total foreign private exposure to Greek sovereign and bank debt, while Italian banks just 4% and Spanish banks 1%.2
Hence debt buybacks carried out by the ECB or the EFSF/ESM would implicitly transfer Greek credit risk from French and German banks (and their sovereign backers) to the Italian and Spanish government, even though their own private banks have negligible exposures to Greek government bonds. Given how market contagion has recently spread to both Italian and Spanish government bonds, such transfers would spread the crisis, not solve it.
How to share the burden
The answer to burden-sharing is obvious. Evoking article 14.4 in the statutes of the ECB and ESCB, national central banks in the Eurozone – rather than the ECB itself or the EFSF/ESM – should undertake the buyback of Greek debt at distressed prices and in the process transfer any credit risk to their national central bank balance sheets. Buybacks should be roughly proportional to the exposure of their private banks to Greek bonds. Given the large exposures of their private banks to Greek debt, this plan would be led by the German Bundesbank and the Banque de France – an appropriate distribution of the risk burden to places where the risk was originally sanctioned.
The buybacks should be accompanied by the exchange at cost (plus a small profit margin) of the purchased bonds for new bonds issued by the Greek government and guaranteed by the Greek central bank. However, since only the Greek sovereign stands behind the national balance sheet of the Bank of Greece, such guarantees must ultimately be backed up by the Eurogroup’s commitment to maintaining Greek solvency. The new bonds should be for longer terms than the retired bonds, to stretch out the profile of Greek sovereign debt, and should carry interest rates say 100 basis points above German debt. At current distressed prices, the buyback plan would reduce the face value of Greek debt by about €5 billion for every €10 billion purchased and exchanged.
The purchasing central bank should add its own guarantee on top of the Greek central bank guarantee, which would enable newly issued Greek bonds to be sold in private markets at face value – and thus at interest rates affordable to Greece.
Several aspects of our plan resemble the burden sharing of the 1980s Brady Plan, in that we foresee debt buybacks that result in a sizable reduction of the principal value of the debt and in the process provide private creditors with safer bonds.
The ECB should play its part to encourage rapid market acceptance of the newly issued Greek debt by ending the privileged position that all Greek debt currently enjoys – namely, it is accepted by the ECB as collateral for loans to private banks. Following the new plan, only newly issued Greek debt would be eligible as ECB collateral. This limitation would encourage private holders of Greek debt to sell their bonds on the secondary market at distressed prices – accelerating the write-down in the face value of Greek sovereign debt.
Judging from available data on individual bank holdings of Greek government bonds, we do not believe that the capital losses associated with buybacks at current market prices will materially affect the capital position of banks outside Greece itself. We believe it appropriate that the Bank of Greece also participate in the buyback plan, but would only be able to do so through the explicit commitment of additional EFSF funds to recapitalise the affected Greek banks, which (similar to Irish banks) would effectively transfer risk largely onto the public sector. After a period of years and financial healing, Greek government equity holdings in Greek banks could add to the pool of assets privatised by the Greek government.
Eurozone national central banks would announce the scheme’s creation and immediately purchase a sizable chunk of Greek debt at currently distressed prices. The subsequent timing and extent of debt buybacks should be used as an incentive for the Greek government to stick to its IMF programme and expeditiously achieve a sizable primary surplus. The precise accounting for associated mark-to-market losses for private banks could be stretched out over an appropriate time period to ensure their solvency.
What about Article 125?
What about Article 125? A close reading shows that “mutual financial guarantees for the joint execution of a specific project” are permitted by the text, and that’s exactly what the plan envisages: mutual guarantees to stabilise Greece and preserve the Eurozone. Fortunately, in December 2010, the ECB set a precedent when it accepted Ireland’s national €50 billion Emergency Liquidity Assistance programme – opening the door for other national central banks to perform similar functions.
The plan's merits
The plan has advantages.
- First of all, there is no need for
private-sector involvement or the associated selective default rating. In the light of market contagion, avoiding any precedent for
private-sector involvement in the actions taken by Eurogroup facilities seems highly desirable.
- Secondly, there is no further increase in the ECB’s balance sheet exposure to Greek credit risk (or for that matter other peripheral countries). Instead, credit risk is transferred to national Eurozone central banks in rough proportion to their existing exposure through their own private banks. Only the additional and more flexibly employed EFSF funds committed to recapitalising Greek banks would result in the redistribution of contingent financial burdens across the entire Eurogroup.
What about disadvantages? Foremost, the plan will elicit screams from the German Bundesbank. However, as the plan is as much a national bank bailout as it is a helping hand to Greece, the Bundesbank should blame its colleagues in Bafin rather than Athens for now forcing it to swallow hard and do what needs to be done.
Gros, Daniel and Thomas Mayer (2011), “Debt reduction without default?”, VoxEU.org, 11 February.
2 BIS table 9E available here.