Debt deal may compound Greece's woes

The bailout package announced by Euro Finance ministers for Greece is more of the same — a can-kicking exercise which is unlikely to last.

The key ingredients of the deal are:

Greece government would be given ¤130 billion to pay down its creditors and also for its re-financing needs.

The plan is to reduce the Greek debt to GDP ratio from 160 per cent to 120 per cent by having a dual approach of austerity and reducing the NPV of the Greek debt by making the creditors take a voluntary haircut of around 53.5 per cent on their debt holdings — by reducing the coupon payments on the debt and extending the maturity of existing debt

The European Central Bank (ECB) has swapped the Greek bonds worth about ¤50 billion that it was holding in its books with another set of bonds that won't be subject to any future forced restructuring like those held by private bondholders.

THREE FALLACIES

Let us examine the fallacies in each of the above three salient points of the deal. How are the ¤ 130 billion expected to be distributed among various parties? As can be seen from the graph, only 19 cents for every dollar goes into spending inside Greece, the rest gets paid to the creditors. So almost 80 per cent of the European taxpayers' money is being channelled to the banks and financial institutions.

Secondly, the plan to reduce the Greek debt burden from 160 per cent of GDP to 120 per cent of GDP without seriously whittling down the debt held with the private sector banks/creditors would prove to be a mirage.

According to the studies done by Kenneth Rogoff and Carmen Reinhart, no country save for Swaziland has ever came out of the debt trap without hard restructuring of its debt or currency devaluation. With Greece being part of the Euro, currency devaluation is not really an option. Without the option of massive currency devaluation or such a restructuring, a cursory understanding of economics would reveal the near improbability of bringing down the Greek debt load.

From basic economics we know that a change in private sector savings is equal to the change in the government spending net of change in the current account balance. Greece is currently running a current account deficit of 6.7 per cent of GDP.

We assume it remains constant (or rather, cannot be reduced); as part of the Euro, Greece has relatively open borders for free flow of goods and labour within the Euro Zone, making it difficult to impose huge tariffs and duties on imports. Now the government's primary deficit is planned to be reduced from 2 per cent of GDP (total deficit is 9.5 per cent) in 2011 to a surplus of 4.5 per cent.

This can only happen with a sharp reduction in Greek Savings, or if the Greek citizens can come in and take more debt. With the private sector in Greece equally leveraged like the government and the banking sector facing severe capital crunch, it would be difficult for the Greeks to take in more debt.

As a result, the proposed massive public austerity would lead to a sharp reduction in the savings rate. This would cascade into the banks calling back the loans already given to corporates and public, thus further lowering the growth rates and in turn the government tax revenues.

The chart describes this growth conundrum. This austerity drive, if not accompanied by massive debt restructuring/forgiveness or currency depreciation, would lead Greece into a vicious circle of a deflation-depression spiral.

THE WAY OUT

Lastly, the swap of bonds that the ECB has done is going to set a dangerous future precedent, as now the sovereign bonds held at ECB would rank senior in any future restructuring.

The next time ECB buys the sovereign debt of Spain and Italy, it could lead to further turmoil among private bond holders.

The current debt deal would only ensure that the Greek depression that has continued for the last 5 years, carries on for longer.

The only way out for Greece in getting back to a sustainable growth trajectory is to either restructure its debt even more, wherein the private bondholders may end up getting completely wiped out (the ECB holds about 40 per cent of Greek debt which as mentioned earlier is hands-off to restructuring), or break out of the Euro Zone and re-ignite its industries with a competitively devalued currency.

(The author is an independent financial consultant at Random Chalice Financial Research, Delhi)