An extreme necessity

GREECE'S prime minister, George Papandreou, faced the television cameras on Friday 23rd April to anounce that his government would draw on emergency aid to tide it over for the rest of the year. Mr Papandreou decribed the rather embarassing request to to other euro zone members and the IMF as “an extreme necessity.” This followed a week in which yields on Greek bonds reached an alarming 8.9%. That in part reflected an announcement by Eurostat, the European statistics agency, that Greece's budget deficit reached 13.6% of GDP in 2009, even worse than it had previously thought. The agency added that the number might be revised up again, owing to the poor quality of the available data. Moody's, a credit-rating agency, responded by giving the latest of many downgrades by agencies to Greece's sovereign bonds.

The interest rate for emergency aid from other members of the euro zone will be 3.5 percentage points above the benchmark “risk-free” rates for euro loans. That works out at around 5% for a fixed-rate loan, which is less than markets were asking of Greece before the deal was struck but still steep. Portugal and Ireland, the next-riskiest borrowers in the euro area, pay less than half as much for three-year money. Germany pays a mere 1.3%.

The IMF is expected to make €15 billion available, at interest rates that are likely to be a little kinder to the Greeks. The resulting package of €45 billion should be enough to finance Greece's budget deficit for the rest of this year as well as repay its maturing debts. Yet Greece is likely to need far more support than this as it struggles to put right its public finances.

An earlier analysis by The Economist suggested that Greece would need at least €75 billion of official aid. We based this figure on several assumptions: that Greece would need five years to stabilise its ratio of debt to GDP; that it could take the pain of a brutal fiscal retrenchment; that private investors would still be willing to refinance existing debts, at an interest rate of 6%, if a rescue fund covered the country's new borrowing; and that the economy would start to grow again in 2013.

An updated set of projections is set out on the right. We have made two changes so the analysis is a bit rosier. We now assume that Greece cuts its budget deficit, as a share of GDP, by four percentage points this year, as planned, so it has less to do later. We also assume that the interest charged on all maturing and new borrowing is 5%, in line with the cost of the aid offered by Greece's euro-zone partners. With those changes, we reckon Greece would need to cut its primary budget deficit (ie, excluding interest costs) by 12 percentage points to cap its debt burden—a slightly less fierce adjustment than in our first simulation. On that basis Greece will run up an extra €67 billion of debt by 2014, by which time its debt will stabilise at a scary 149% of GDP. That sum is less than our previous estimate, but still half as much again as the amount on offer.

Some will see this scenario as too pessimistic. It is far gloomier, for instance, than that envisaged in the EU retrenchment programme, which assumes that Greece will get its deficit below 3% of GDP in three years and that the economy can continue to grow as it does so. However, even with a more benign assumption about growth, Greece's debts would still be very large. For instance, suppose that any losses in nominal GDP during recession are quickly recovered. Debt would still then stabilise at 142% of GDP.

It will be hard for Greece to make such savage cuts in its budget and emerge from recession at the same time. Furthermore, prices and wages will have to fall if Greece is to regain the cost competitiveness needed for sustained economic growth. That will drag down nominal GDP in the short term, and make budget cuts more difficult to carry out.

Our analysis may even be too optimistic. If economic growth does not return, deficit reduction proves too painful or interest rates are much higher than we assume, the debt ratio is likely to spiral upwards until default becomes all but inevitable. Even if that is avoided, Greece's rescuers may have to shoulder more of the financing burden than we have estimated, should private investors reduce their exposure to Greece.

They have plenty of reasons to do so. As Greece's debt mountain grows, investors are increasingly likely to shun its bonds in favour of those of other, more creditworthy, euro-zone countries. Though IMF cash is welcome, private investors know that the fund is first in the queue when money has to be paid back. A euro-zone rescue party may also demand priority.

The bolder sort of investor may reckon that the high yields on offer are ample reward for the risk that Greece may be unable to repay all it has borrowed. But some will be more cautious. And others may judge that an interest rate big enough to compensate for the risk of default would only add to the pressure on Greece, making default more likely. Asian central banks that want to balance their dollar holdings with euros may choose to park their cash in France or Germany and save themselves any worries about Greece and its politics.

Greece's euro-zone partners could find themselves with a large and open-ended commitment to roll over the country's existing debts and to provide cash to cover its budget deficits. The rescue package may over time evolve into a rolling series of soft loans, at ever-lower interest rates and increasing maturity, designed to prop up Greece and keep default at bay. Such loans—in effect, grants—would amount to a kind of fiscal drip-feed. That could spur a political backlash, and perhaps legal challenges, in the countries supplying the funds.

The default option

Is a sovereign default by Greece imaginable? Conventional wisdom has it that sovereign defaults are always messy and painful. In fact the lesson of such defaults over the past decade or more is that this is not necessarily so. More than a dozen emerging economies have restructured their sovereign debt in the past decade without huge losses of output and without paying enormous penalties in exclusion from capital markets or higher spreads. With a few exceptions (notably Argentina) the process has been much quicker than in earlier sovereign restructurings, and governments and creditors have managed to work together. Governments sometimes negotiated a restructuring with creditors before formally missing a payment of interest or principal—a process known, in the jargon, as “pre-emptive” restructuring. Legal innovations to encourage creditors to take part in restructurings and make it harder for holdouts to litigate have helped.

In 2003 Uruguay restructured all its domestic and external debt, exchanging old bonds at par and at the same coupon rate for new ones but stretching maturity dates by five years. The country returned to capital markets a month later. The “haircut”, or loss to bondholders, was small (13.3%, in net present value), as were the amounts restructured ($5.4 billion), but it showed that orderly sovereign workouts are possible. Countries such as Jamaica and Belize have had orderly restructurings recently.

Greece is different because it has much more debt outstanding and because bondholders may face a more severe haircut—although with sufficient fiscal consolidation a more modest restructuring could be feasible. Sovereign-debt lawyers say that in some ways a restructuring of Greek debt would be easier than many people think. But other things would be new and harder, especially the complexity caused by credit-default swaps, which have not yet played a big role in any sovereign-debt restructurings. It is uncertain, for instance, whether a pre-emptive restructuring would trigger the default clause in credit-default swaps. But Lee Buchheit, a leading sovereign-debt lawyer, says that the biggest risk in most debt-restructuring cases is governments that try to put off the inevitable. “By far the greater risk is pathological procrastination by the debtor in the face of an obviously untenable financial situation,” he argues, in which a country pursues frantic and ruinously expensive emergency financing in the lead-up to an eventual restructuring.

Would a defaulting country have to leave the euro? No. It is perhaps natural to conflate default with devaluation because they often occur together. But a euro member has no currency to devalue. Nor is there a means to force a defaulter out, since membership is meant to be for keeps. A new currency would have to be invented from scratch, a logistical nightmare. All contracts—for bonds, bank deposits, wages and so forth—would have to be switched to the new currency. The changeover to the euro was planned in detail and in co-operation. The reverse operation would be nothing like as orderly. A country that had lost the faith of investors in its public finances would find it hard to reconstruct a sound monetary system. Default by a member would be a body blow to the euro's standing. But it need not spell the end of the currency.