How to orchestrate an orderly and credible restructuring of Greece’s debt

Pimco’s Myles Bradshaw outlines the options for Greece.

Ahead of the European Union summit on Thursday, markets are bracing themselves for a restructuring of Greek debt.

I don’t want to dwell on the various reasons for this, but suffice it to say that we don’t expect Greece to issue bonds as planned in 2012. Political support for additional loans to Greece without any bondholder bail-in is low, especially from Germany and other core eurozone countries. Instead, I want to discuss what a Greek restructuring could look like – and now that the contagion has reached Italy – what can be done to contain contagion risks.

While the question of when Greece should restructure its debt is mainly a political decision – though it increasingly looks like it could happen this year – how it should restructure its debt remains an open question. Any eventual restructuring plan would also be decided by politicians, but its impact would be influenced by a range of reactions.

Before speaking to this, it is important to identify the objectives of a “relatively orderly” restructuring:

1. To provide debt reduction and solvency relief for Greece – but it is important to note that a potential debt restructuring would not necessarily remove the need for fiscal austerity and structural reform, as both these are necessary to achieve a primary surplus and recover competitiveness – nevertheless, it can reduce the execution risks.

2. Win political support in creditor European Union (EU) countries – particularly in Germany, Netherlands and Finland – and with the International Monetary Fund (IMF) for continued financial support for Greece.

3. Identify the unintended consequences of restructuring, namely potential contagion and the accompanying policy measures that could counter a disorderly process.

Solvency Relief for Greece

Identifying how much solvency relief Greece needs is complicated, not least because there is no magic debt ratio that is sustainable. Debt “sustainability” is often defined as a function of a sovereign’s debt load, nominal interest rates, the primary surplus (i.e., fiscal balance before interest payments) and nominal GDP growth.

A restructuring must either reduce the debt load and/or lower the interest rate. This serves to lower the primary surplus that Greece must achieve in order to stabilize its debt over time. And fortunately for Greece, the austerity measures that can be scrapped would be a multiple of this change in the fiscal target. That’s because by taking less money out of the economy, growth should be stronger, tax revenues higher and public finances healthier (this is the so-called fiscal multiplier). Lower interest payments should also serve to reduce Greece’s financing needs and help buy political support in Germany and elsewhere.

Restructuring therefore reduces execution risk and increases the political viability of the plan from the perspective of both Greece and the EU. As context, the new IMF program anticipates austerity measures worth 10.4% GDP in total to target a primary surplus of 6.4% GDP in 2014. In other words, to make a difference, debt worth more than €30 billion (the target figure set by EU ministers) has to be restructured.

Extending the maturity of debt is important but on its own it is insufficient. A maturity extension of short-term bonds may reduce Greece’s refinancing needs and therefore make the sovereign less vulnerable to a change in creditor sentiment. But it may only improve debt sustainability if Greece can raise GDP growth in the interim.

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