A HORA DA VERDADE

Moment of truth for the eurozone
By Martin Wolf

The biggest question in any debt crisis is whether a credible path back to solvency can be found. For Greece, this now seems very unlikely. The same is true, to a lesser extent, for Ireland and Portugal. This raises three further questions. First, how big is any required restructuring? Second, who should bear the cost? Finally, is restructuring enough? If the answer to the last question is No, then one has to ask whether the currency union will last in its current form.

On the first of these questions, an analysis by Citigroup provides a negative answer. According to this analysis, by 2014 the ratio of gross debt to gross domestic product will have risen to 180 per cent in Greece, 145 per cent in Ireland and 135 per cent in Portugal. In none of these cases will the debt ratio start moving downwards over this horizon. Spain looks far better, with a debt ratio at about 90 per cent of GDP in 2014, though its path, too, will not have turned down. (See chart.)

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The assumptions behind these forecasts are: a cumulative fiscal tightening between 2011 and 2014, inclusive, of 10.8 per cent of GDP in Greece, 8.3 per cent in Portugal, 7.3 per cent in Ireland and 5.7 per cent in Spain; interest cost of new funding rising from close to 5 per cent to 5.6 per cent in 2014 for Greece, Portugal and Ireland (determined by a weighted average of rates from the International Monetary Fund and the European Financial Stability Fund) and higher rates for Spain, since the latter will rely on the market; and, finally, privatisations and bail-outs. The analysis also assumes that a percentage point of fiscal tightening would lower growth by half as much.

Assume that these countries could borrow affordably in private markets at a gross debt ratio of 80 per cent of GDP. Assume, too, that European governments ensure that the IMF takes no losses. Then, the reduction in value of the rest of the debt would need to be as much as 65 per cent of GDP for Greece, 50 per cent for Ireland and 45 per cent for Portugal. The total “haircut” would be €423bn: €224bn for Greece, €107bn for Ireland and €92bn for Portugal.

One can quibble over the figures: these may be too pessimistic. But, without a big restructuring, these countries are now most unlikely to be able to finance themselves in the market on bearable terms. That is also what markets are saying: spreads on 10-year bonds over yields on German Bunds are 1,340 basis points, or 13.4 percentage points for Greece, 875 basis points for Ireland and 818 basis points for Portugal. This is why they are all now in official programmes. Worryingly, spreads for Spain are also now uncomfortably high, at 240 basis points, while those for Italy have reached 190 points. The eurozone, in short, is confronting a frightening sovereign debt challenge, aggravated by the dependence of its banks on support from its states and of its states on finance from its banks.

Now turn to the second question: who should bear the losses? If all the haircuts were to fall on private creditors, their losses in 2014 would be 97 per cent of their holdings of Greek debt, 63 per cent of their Irish debt and 60 per cent of their Portuguese debt. Official creditors would, by then, have to bear a substantial part of the total losses. Since governments would also need to bail out some of the holders of the restructured debt, particularly the banks, the eurozone would be revealed as a “transfer union”. Note, moreover, that this would occur despite a big fiscal effort in the affected countries. But even that would be insufficient to reverse the unfavourable debt dynamics in the medium term, partly because GDP growth is likely to remain so weak.

Against this background, proposals for rollovers by the banks, whether or not deemed technically a default, are neither here nor there. Much more to the point would be debt buy-backs at levels close to current market prices, as discussed in last week’s statement on Greece of the Institute for International Finance, which brings together the biggest international banks. That would crystallise losses. So be it. Let reality be recognised. As the Financial Times has also argued this week, the case for offering a menu of options with partial guarantees, similar to those under the 1989 Brady plan for Latin American debt, is powerful.

The question is whether such voluntary debt reductions would be enough, particularly for Greece. The answer is No. Governments would also have to play a part, by either accepting losses on the face value of their loans or ensuring lower interest rates, as proposed by Jeff Sachs of Columbia University. These are just two ways of achieving a lower net present value of debt service.

The dangers of debt relief are great. But the chances of success with denial are close to zero. True, it is possible for an ever greater share of the debt to be assumed by governments, so bailing out private creditors. Yet, ultimately, the cost of the debt owed to official sources will have to be cut by lowering interest rates or reducing sums outstanding.

It is not a question of whether such adjustments will have to be made, but of when. The history of such crises strongly suggests that it should be done sooner rather than later. Only after debt is on a sustainable path is confidence likely to return. Allowing foolish lenders, incompetent regulators and sloppy policymakers to hide past mistakes is a bad excuse for endless delays.

The doubt, in truth, is not over whether relief on the present value of the debt service is required. The real questions are elsewhere. One is over how to manage a co-operative debt restructuring. The other is over competitiveness and the return to growth. Some point to the success of Latvia in managing its so-called internal devaluation. But its GDP is 23 per cent below its pre-crisis peak. That is a depression. Moreover, the more successful a country turns out to be in cutting its costs, the worse the debt burden becomes. Thus, debt restructuring is merely a necessary condition for an exit. It is unlikely, in all cases, to be enough. Some economies may just wither away.

Alternatively, politicians may pull their countries out of the eurozone regardless of short-run costs. It is far too early to assume this will be the outcome, though some already do. But if there is to be any chance of avoiding this outcome, realism is required. At some point, the present value of the cost of debt must be drastically lowered. This does not have to happen today. But it has to happen soon enough to give people hope. In its absence, failure is not just likely. It is close to a certainty.