International press informs us that the Greek government believes it has weeks or perhaps months to negotiate a new deal with its creditors. The basic idea of the new Greek finance minister Yanis Varoufakis is that Greece remains in the Eurozone even once the financial assistance agreement has expired end of February thanks to a European Central Bank propping up the weak Greek banking system. This, however, will hardly be possible for a number of reasons.
- Already now, Greek government debt should become non-eligible as ECB collateral. The Greek finance minister has declared that his country is insolvent. When a finance minister declares the insolvency of his country, then the quality of all the debt he has issued should fall below the relevant thresholds for Emergency Liquidity Assistance as well as standard monetary policy operations. While I do not believe the ECB will be so consequential as to do this immediately, I also cannot believe that it will just continue lending for a long time.
- The ECB’s single supervisory mechanism (SSM) should now raise serious questions about the solvency of Greek banks. Greek banks hold significant amounts of government debt. As a supervisor, it should ask tough questions to find out whether the banks would withstand a default of its government.
- The SSM should also prohibit Greek banks to buy any paper issued by the insolvent Greek government. This means that indirect government funding by issuing short-term T-bills and repo-ing them at the ECB or in the ELA will become impossible.
In my analysis, the case for insolvency is far less clear. The insolvency of a country depends on whether it is able to pay the interest on its debt. Greece’s interest burden is likely to be as low as 2% of GDP in 2015 according to the calculations of my colleague Zsolt Darvas. This makes the debt burden comparable to France (2.3%) and Germany (1.8%). Of course, one can argue that it is the high future debt cost that weighs currently on the Greek economy. In the assessment of markets, this was however a negligible concern until recently. Only last year, Greece could issue 5-year sovereign debt at interest rates of only 4.95%. Nevertheless, the high debt burden can indeed prove damaging for the Greek economy, especially if nominal growth will be well below the predictions of the official institutions in the next years as it seems likely right now.
The Greek finance minister has therefore posed a difficult challenge to the EU and the IMF. By talking about insolvency, he has raised the funding needs for Greece’s banking system and made government fund raising on capital markets impossible. The recent government decisions have seriously raised doubts about Greece and capital is by now moving out of the country as quickly as possible, putting to a test the limits of ECB’s funding possibilities against dubious collateral. It is therefore clear that the government will have to quickly find an agreement with its creditors if it wants to stay in the euro area. It is also important to highlight that the current uncertainty is bad for the Greek economy. So what could such a deal look like? Here are my essential elements.
- Reverse the additional government spending announced last week. When a country is insolvent and increases its spending, it is de facto decreasing its budget constraint at the expense of others. Tsipras has the democratic right to negotiate but he has no democratic legitimacy to spend money from taxpayers in other countries.
- There should be a Eurogroup meeting (the next meeting is scheduled for 16 Feb, which may be too late) to discuss the Greek situation. Syriza has won an election for a reason. The situation in Greece is indeed bad and the euro area should enact solidarity. For example, additional government spending to alleviate serious problems in the health system could be funded by special and additional EU funds.
- The immediate funding needs of Greece need to be discussed and covered. A technical default would undo years of work to regain market access. More worryingly, it would leave the government in a position in which it will be hard to fund all its services and/or it would have to default on its obligations to the IMF, which amount to 7.9 billion for 2015. For the ECB, the repayment amounts to 6.5 billion in July/August 2015.
- As regards the debt, it is in the interest of the creditors as well as Greece to achieve a solution in which debt dynamics do not explode, as this would not only undermine the recovery in Greece further but also make the repayment impossible. It is also in mutual interest to have a solution that is robust to different kinds of shocks in order to prevent a repetition of a drama as we currently see it. A sensible solution would be to agree to index the size of the debt burden to a baseline GDP scenario. A decision to adjust the debt burden symmetrically could be taken every 3 years when GDP deviations are clearly visible. This would mean that Greece would have to repay more if GDP performs better and less if GDP performs worse than the baseline. One could also agree on an extension of the maturity and a reduction in the interest rate on the remaining bilateral loans.
- Greece will have to commit to fulfil a number of conditions that make the baseline growth scenario achievable.
- As regards the Troika, Tsipras would have been well-advised to use it to achieve some of his promises such as finally taxing the rich oligarchs in the country. Yet, it is probably too late to save the Troika in its old form. The ECJ’s General Attorney did cast some doubt on the participation of the ECB in the Troika in case of an OMT programme. One could therefore foresee a new construction, in which the ECB would not be part of the missions. In any case, the ECB will be present in the country as a single supervisor and will have to ask tough questions to the Greek banks.
- Finally and in the interest of risk management, the euro area should agree to increase the Juncker plan with national fiscal resources in order to boost aggregate demand in the euro area as a whole. While this will hardly help Greece with its small export sector, it would benefit a number of other countries that are trapped in a low growth scenario. In doing so, the risk of election of radical parties would go down and painful structural adjustment would be made easier.
Overall, it is clear that both sides have a strong interest in preventing an exit from the euro area, which will be unavoidable if an agreement is not reached soon. A cooperative solution is not unachievable but it requires Greece to go to the Eurogroup as a reasonable negotiating partner and it requires the euro area to be ready for some concessions.