Without an extension of its financial support package, Greece will not have the resources to make a €7 billion debt payment that is due in July.
As the deadline nears, fresh chills have rippled through global credit markets, with concerns about an impasse among Athens’ official creditors on the next tranche of the financial support package leading to a sharp increase in government bond yields last month. Higher interest rates could undermine the sustainability of the government’s debt dynamics and revive fears of the “Grexit” scenario in which Greece is forced or chooses to leave the euro zone.
Nerves have been steadied, and, in the hopes of a diplomatic breakthrough, eyes have turned to Malta, where the Eurogroup finance ministers will meet on April 7.
But ministers meeting on the Mediterranean archipelago will confront long-standing divisions between the interests and objectives of the “troika” of Greece’s official creditors — the European Central Bank (ECB), the European Union (EU) and the International Monetary Fund (IMF). The ECB has provided liquidity consistent with ECB President Mario Draghi’s dramatic commitment in 2012 to “do whatever it takes” to preserve the euro, but its willingness to accept Greek bonds as collateral for continued advances is contingent on the extension of financial support. The European Union and its members, meanwhile, want to prevent a Greek default, both to preserve the integrity of the euro and to avoid writing down the value of loans they have already extended to Athens. The IMF is conflicted. On the one hand, its European members clearly want the bailout to go forward without delay. On the other hand, other IMF members are concerned about the degree of adjustment that Greece has been required to sustain.
The challenge for IMF management is to assist members in striking a balance between “financing” and “adjustment.” In the Bretton Woods era, during which capital controls limited the size of balance of payments problems to a few percentage points of GDP, commitments on policy actions that, if fully implemented, would close balance of payments gaps and raise growth were sufficient to achieve this balance. (The operative phrase here is “if fully implemented.” In the past, some EU members have doubted Athens’ commitment to reforms and questioned its implementation of agreed measures. These countries have been adamant that the IMF be involved to monitor compliance in part, perhaps, because of worries that the EU officials in Brussels would be too “soft” on an EU member.)
Such measures entailed the reduction of domestic absorption — that is, consumption, government expenditures and investment. With the advent of capital account liberalization and integrated capital markets, however, countries today confront much larger crises in the capital account. These crises resemble panicked bank runs that play out in a matter of weeks — not the balance of payments problems in the current account of earlier days, which evolved over a matter of months or quarters. In such circumstances, securing balance of payments of adjustment through a reduction in absorption alone could destroy growth, making it impossible to achieve the felicitous balance between “financing” and “adjustment” that is the IMF’s mandate. The IMF must therefore be satisfied that a member’s debt dynamics are sustainable. This is what the latest act in the Greek debt drama is about.
The simple analytics of debt sustainability consists of three elements: the government’s primary surplus (tax revenues less expenditures net of interest payments), the real interest rate on the stock of debt and the growth rate of the economy. For a given initial level of debt relative to the size of the economy (debt-to-GDP ratio), a lower primary fiscal surplus (revenues less expenditures net of interest payments), higher real interest rate or lower growth rate will make the stock of debt rise. Bear in mind that an increase in the debt-to-GDP ratio does not automatically equate with unstable debt dynamics. Debt ratios may be high in some countries and still be sustainable; other countries may be at risk of an “explosive” debt path at a much lower ratio. Moreover, as it is future values of surpluses, interest rates and growth that determine sustainability, there is ample room for the various parties to make different assumptions regarding the evolution of debt.
These factors explain why debt sustainability is more of an art, and less of a science, and why there is considerable scope for disagreement within the troika. In this respect, European capitals, including Athens, want the Greek financial support package to continue “as is.” The IMF is balking.
The IMF is reportedly concerned that Athens will be unable to deliver the primary surpluses required to assure debt sustainability. These concerns may reflect the fact that, with the United States nearing full employment, global interest rates are on the rise. Higher interest rates would have direct and indirect effects on debt sustainability: a direct effect in terms of the larger primary surplus that would be needed to preserve debt sustainability, and an indirect effect stemming from the fact that, while higher interest rates reflect growth in the United States, they could hurt the prospects for growth in countries, such as Greece, operating below full employment. (Higher US interest rates would normally be expected to lead to a depreciation of currencies of countries operating below full employment, providing a stimulus to growth. However, this potential beneficial effect could be modest in the case of Greece given that it uses the euro and that the ECB sets monetary policy on the basis of euro-zone-wide conditions.) At the same time, reasonable doubts regarding Athens’ ability to deliver primary surpluses year in, year out over the foreseeable future would undermine debt sustainability. And, as a rules-based institution, the IMF is obliged to follow its debt sustainability methodology, which requires its staff to ask: “Are the projections for the primary balance realistic?” Unfortunately, the answer may be “no.” And, given the existing stock of Greek debt, that response would make the debt dynamics unstable.
The implication of the IMF’s position is stark: the debt must be reduced.
This policy prescription is opposed by European creditors. From their perspective, substantial debt relief has already been provided to Greece in the form of lower interest rates and lengthened maturities on Greek debt. While factually correct, this argument is irrelevant: what is past has no bearing on whether the debt is sustainable going forward. Past debt relief might have led to sustainability had there been more robust growth in the euro zone. But with the Greek economy contracting at a Great Depression rate, historically low interest rates were insufficient to reverse the negative debt dynamics, and the debt-to-GDP ratio quickly rose.
There is a further problem, that is, official sector lenders now constitute the bulk of Greece’s creditors. The IMF has long enjoyed preferred creditor status by virtue of being the lender of last resort — the provider of resources to debtors locked out of private capital markets. This role serves a public purpose, namely, the IMF’s objective is to resolve balance of payments problems with a minimum of disruption to the member country, its creditors and the global economy more broadly. In view of this mission, international convention is that the IMF is repaid before all other creditors.
Going forward, the question is what would happen if both the ECB and the European Stability Mechanism, an EU agency charged with providing financial assistance to euro zone members, were to assert preferred creditor status, which would exempt them from a restructuring of Greek debt. This scenario would imply that any possible required debt reduction would be disproportionally borne by the other creditors. In the past, this meant private creditors, but this “buffer” no longer exists. And, with elections in core EU countries pending, there is a political dimension to opposition to debt relief for European governments that have promised their taxpayers no further bailouts to Athens; attempting to negotiate terms in the middle of critical election campaigns would be difficult, to say the least.
Europe has already promised debt relief but is unwilling to specify the terms, fearing a weakening of adjustment effort. The stewards of the central bank and Europe’s stability mechanism may both be hoping that significantly higher growth will allow Greece to “grow out of its debt problem.” A similar assumption was made in the initial approach to the debt crisis of the 1980s. An overhang of debt may be distorting incentives for investment and productive activities and stifling potential growth and creating a debt Catch-22: the lack of growth is contributing to the debt problem, but the high debt burden is preventing growth. At the same time, political considerations may be compressing time horizons, as leaders discount the future too heavily in advance of elections.
So, where do we stand?
Even after substantial debt relief, Greece remains burdened by a debt load that poses a threat to sustainability and an impediment to growth. Firms’ incentives to invest may be distorted by the expectation that future profits will be heavily taxed to service the debt. And the risk of adjustment fatigue that erodes political support for the status quo, resulting in populist policies which may provide short-term relief but ultimately lower long-term growth, cannot be discounted. That scenario is not in anyone’s interest — neither Greece’s creditors’ nor its citizens’. In the extreme, countries may defect from the cooperative equilibrium of sound policies and constructive international engagement and engage in beggar-thy-neighbour policies “destructive of national and international prosperity.”
The IMF was created to prevent this contingency. In the post-Bretton Woods era of large-scale capital flows that can be quickly reversed, this requires mechanisms to deal with sovereign debt problems. At the domestic level, firms can seek legal protection under bankruptcy laws for a “discharge” of excessive debt that impairs their ability to invest and distorts corporate decision. And, while an analogous regime does not exist for sovereign bankruptcy at the international level, the IMF has acted as a quasi-surrogate to help its members resolve payments difficulties quickly and with a minimum of disruption to them, their creditors and international economic and financial stability.
The IMF’s approach to sovereign debt crises has had to evolve, however, given the changes to international finance over the past 40 years. Most important, perhaps, is the evolution of its policies on lending into arrears (LIA). Prior to the late 1980s, the IMF’s operating procedures would not allow it to lend to a member with arrears to private creditors. Needless to say, this rule conferred enormous power to private creditors, who could, in effect, block access to an IMF program to force sovereign debtors to settle their claims. By revising the LIA policy to give members in arrears access to its programs, the IMF shifted bargaining power from private creditors to distressed borrowers. Similarly, a little more than a year ago, it moved further — to allow LIA even when the debtor is in arrears to official creditors. This change reflected concerns that official creditors might block a restructuring for political reasons.
Throughout the evolution of its LIA policy, the IMF has attempted to promote the principle of good faith in the restructuring of sovereign debts. This requires that a debtor seeking IMF assistance engage with its creditors in a timely fashion, share relevant information on the nature of the economic challenges impairing debt servicing and allow for input in the design of a restructuring agreement. Since LIA can alter the balance of bargaining power in negotiations, it would be contrary to sound public policy to reward actions that make it more difficult to come to mutually agreeable restructuring of claims.
The evolution of the IMF’s LIA policy over the last three decades reflects its mandate to help its members strike a felicitous balance between “financing” and “adjustment.” In doing so, it helps to create a framework for debt-restructuring negotiations between distressed sovereigns and their creditors in the same way that domestic bankruptcy laws allow parties to negotiate “in the shadows of the courthouse” at the national level. But, just as domestic bankruptcy laws are administered by independent, disinterested judges, to assist its members strike that balance, the IMF’s assessments must be viewed as independent and impartial.
In this respect, while an optimistic scenario in which Greek growth is sufficiently strong to alleviate the debt problem cannot be dismissed, a more pessimistic scenario akin to the “lost decade” of the 1980s seems to be playing out. In that bleaker vision, the question may arise: How can the IMF promote “good faith” when the creditors are also members of its board?
In some respects, the current impasse within the troika recalls the “muddling through” approach to the debt crisis of the 1980s, in which several debtors were thought to have suffered from high debt loads and a debt overhang that stifled growth. Then, fundamental debt restructuring akin to discharge was postponed until the commercial banks that were the biggest creditors accumulated sufficient reserves to withstand debt writedowns. That strategy was good for the banks and their shareholders. It is less clear that the resulting “lost decade,” as the period is known in Latin America, was in the interests of the debtor countries. That experience led to complaints that the IMF had been used as a debt collector for rich country banks. The Fund is likely anxious to avoid a repetition, albeit with official creditors in place of commercial banks.