Daniel Gros14 March 2011
This weekend, EU leaders agreed to the outlines of a new mechanism to deal with Eurozone debt problems after the current mechanism expires in 2013. The mechanism is a continuation in the leaders' preference for "tough talk and soft conditions". This column argues that the package is merely the next step down the slippery slope of EU taxpayers sharing the burden with Greek taxpayers.
The main focus of this weekend’s extraordinary meeting of EU leaders was Libya – not the Eurozone debt and banking problems (Van Rompuy 2011, European Council 2011). There was informal agreement, however, on the Eurozone debt issue and it confirms a trend that emerged 2010. In short, it is: “No default will ever be allowed, but all bailouts will be preceded by tough talk.”
This general direction has now been clearly set. It will take a major disruption to make the EU convoy change track.
The tough talk was the agreement on the renamed “Pact for the euro”, which contains a list of desirable policy goals but no means to implement them.
The soft conditions came in the form of:
These parts of the deal might be summarised as “more money at cheaper rates”.
Apparently it was also agreed that EFSF might not only provide credits to countries which have lost access to the markets, but could also directly buy the government bonds of these countries. It is difficult to see the difference between primary market purchases of government bonds and providing credit directly to a country. This part of the agreement will be of limited value unless the condition (EFSF programme) is relaxed, as it well might be in future.
This weekend's meeting marks the third time that Germany has talked tough but then caved in when financial markets became nervous. The really tough talk which initiated the latest round of market nervousness came late in 2010 in the form of an agreement between France and Germany, which was then enshrined on 28-29 October 2010 by the European Council whose “Conclusions” (i.e. the official statement of what was agreed) stipulated that:
This sounded tough, but the “sustainability test” will remain a paper tiger.
The litmus test of any such test will be Greece. Most independent observers and investors assume that the public debt of Greece today is not sustainable. However, the official story is completely different. The IMF/EU/ECB mission has already published its own sustainability assessment with a clear conclusion – there is no problem of sustainability.
This optimistic stance of the IMF/EU/ECB troika is not surprising. These institutions could not have started the rescue programme if they had not come to this conclusion.
Even apart from the specifics of the Greek case it is clear that any rescue programme will be structured in such a way that it yields a sustainable path for public finances.
In Greece’s case, the sustainability calculations of the IMF/EU/ECB are based on three simple assumptions:1
Under this combination, the critical debt/GDP ratio will start to decline around 2013.
There are three problems with this rosy calculation.
But this is what the Greek government promises; the Troika’s sustainability assessment thus accepts it as an assumption.
It is highly unlikely that private investors will buy bonds carrying such an interest rate.
The key issue here is a bit technical. According to the Leaders’ informal agreement, new bonds issued after 2013 would contain “collective action clauses”. These clauses (CACs to connoisseurs) are baked-in contractual conditions that make rescheduling easier. Since “rescheduling” means “partial default” from the investors’ perspective, CACs are worrying to private investors – even more so since about half of Greek public debt is “official” (i.e. own by the Troika) and all of this will be senior to private debt. In plain English, this means that official debt-holders get to jump to the head of the re-payment queue if things go wrong. Private investors who think all this through – and who fail to share the Troika’s faith in the three assumptions – will demand an interest rate that compensates them for the probability of rescheduling losses.
The interest charge on the existing €110 billion programme for Greece (based for now on bilateral credits, but later to be rolled into the new facility to be called the European Stability Mechanism, ESM) has been lowered to below 5.5 %, the interest assumption has also received official approval. And given the logic discussed above, private investors will shy away from Greek debt and the ESM will have to take up the slack.
Since Greek public debt already amounts to over €300 billion, the size of the ESM will have to increase after 2013. The Greek package alone is likely to require about 60% of its financing capacity. But this is not the end of the problems.
Once most Greek public debt has become official debt, a whole new game starts. At this point restructuring of private debt is no longer an option – the private lenders will have already backed out. The collective action clauses that were so cleverly included will be irrelevant. From this point onwards the ESM can only restructure its own claims on Greece.
Restructuring in this situation would mean European taxpayers taking the hit in terms of longer maturities and lower rates. At that point, expect more of the same, i.e. tough talk and soft conditions.
On 11 March the European Council has once more decided to kick the can down the road. Once again they have failed to think through the consequences of their actions from the perspective of the markets. They failed to think through what this weekend’s decision will mean for the options they will face in the future.
Having come this far it becomes very difficult to change direction. All our leaders can do now is to hope that the road will take a decisive turn for the better; and that the new ‘Pact for the euro’ helps them avoid future accidents.
Van Rompuy, H. (2011). “Remarks by Herman Van Rompuy President of the European Council at the press conference following the Informal Summit of the Heads of State and Government of the Eurozone.” European Council (2011). Conclusions of the heads of state or government of the Euro Area, 11 March 2011.
1 A “primary” budget surplus (i.e. not including interest payments on the debt) runs down the debt/GDP numerator, GDP growth runs up the denominator, and interest payments run up the numerator. Sustainability means that the debt/GDP ratio doesn’t grow forever.
Daniel GrosDirector of the Centre for European Policy Studies, Brussels
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